State Statutory Restrictions on Financial Distributions by

Washington Law Review Washington Law Review

Volume 55 Number 2

4-1-1980

State Statutory Restrictions on Financial Distributions by State Statutory Restrictions on Financial Distributions by

Corporations to Shareholders Corporations to Shareholders

Richard O. Kummert University of Washington School of Law

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STATE STATUTORY RESTRICTIONS ONFINANCIAL DISTRIBUTIONS BY

CORPORATIONS TO SHAREHOLDERS

Part I

Richard 0. Kummert*

I. INTRODUCTION

After a long period of dormancy, interest appears to have quickened inthe possible reform of the statutory provisions enacted by most states toregulate payments by corporations to their shareholders. The Californialegislature recently adopted a relatively unique series of restrictions ondividends and repurchases of shares as part of an overall revision of thatstate's Corporations Code. I And the Committee on Corporate Laws of theAmerican Bar Association section on Corporation, Banking and BusinessLaw recently revised almost all of the financial provisions in the ModelBusiness Corporation Act. 2 In view of these developments, it is fair toassume that a significant number of legislatures 3 will soon considerwhether to enact the revised Model Act provisions, to retain the oldModel Act provisions, to enact the new California provisions, or possiblyto enact an entirely new series of provisions. Unfortunately, relatively lit-

* Professor of Law and Associate Dean, University of Washington; B.S., 1953, Illinois Institute

of Technology; M.B.A., 1955, Northwestern University; LL.B., 1961, Stanford Law School.I am indebted to Professors Charles A. D'Ambrosio, Charles W. Haley, Lloyd C. Heath, and

Robert C. Higgins for their comments. They are not in any way responsible for any errors remaining.1. 1975 Cal. Stats. ch. 682, as amended by 1976 Cal. Stats. ch. 641, 1977 Cal. Stats. ch. 235,

1978 Cal. Stats. ch. 370, 1979 Cal. Stats. ch. 711 (codified at CAL. CoRP. CODE §§ 1-2300 (West1977 & Supp. 1979)). See CAL. COR'. CODE §§ 500-11 (West 1977 & Supp. 1979) (critical financialprovisions of the Code).

2. The Committee adopted the revised provisions in December 1979. Letter from Elliot Gold-stein, Esq., Chairman of the Committee, to Richard 0. Kummert (April 15, 1980) (on file withWashington Law Review). The full text of the amendments appears in Committee on Corporate Laws,Changes in the Model Business Corporation Act-Amendments to Financial Provisions, 34 Bus.LAw. 1867 (1979).

The Act was amended to eliminate all references to "stated capital," "capital surplus," and"earned surplus" as limitations on dividends, distributions, and repurchase and redemptions ofshares. Only the Act's provisions related to consideration acceptable for share issuances were leftunchanged.

3. According to the Model Business Corporation Act Annotated, the Model Act has been usedas the basis for the corporation statutes of 25 states. See 1 MODEL BUs. CoRP. Acr ANN. § 1, 2 (2d ed.1971, Supp. 1973 & Supp. 1977).

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Washington Law Review

tle 4 of the otherwise ample5 recent literature on corporate financial provi-sions has focused on the basic policy questions that must be resolved be-fore an informed choice can be made between alternative means of regu-lating corporate financial distributions. This article attempts to fill thatvoid.

II. SOCIETAL INTERESTS IN CORPORATE FINANCIALDISTRIBUTIONS

State statutory and case law related to corporate financial distributionsis the product of an attempt to balance the conflicting interests of the vari-ous groups concerned with the amount of such distributions (commonshareholders, senior security holders, general creditors, corporate offi-cers, employees, and the public) 6 inter se and with the interests of thevarious groups involved in the administration of the legal limitations (di-rectors, lawyers, accountants, and judges). This section first considersthe public interest in the total amount of dividends paid and shares repur-chased by corporations. It then considers the interests of each of the re-maining groups concerned with the amount distributed as dividends or byrepurchase of shares. It finally considers the interests of the groups con-cerned with administration of the legal limitations on corporate financialdistributions.

A. General Effects of Corporate Financial Distributions

Shareholders receiving financial distributions from corporations mayrealize income subject to tax, 7 and thus governmental units imposing in-

4. See J. DEUTSCH & J. BIANCO, THE LAW OF CORPORATIONS-WHAT COPRORATE LAWYERS Do629-60 (1976); B. MANNING, A CoNcisE TEXTBOOKON LEGAL CAPITAL (1977); Shepherd & Scott, Cor-

porate Dividend Policy: Some Legal and Financial Aspects, 13 AM. Bus L.J. 199 (1975); Note, TheBusiness Judgment Rule and The Declaration of Corporate Dividends: A Reappraisal, 4 HOFSTRA L.REV. 73 (1975).

5. See, e.g., I MODEL BUS. CORP. ACT ANN. § 2, at 45-46, § 6, at 272-75, § 45(a), at 909-13 (2d

ed. 1971) (citation of articles).6. See, e.g., W. CARY. CASES AND MATERIALS ON CORPORATIONS 1485-86 (4th ed. 1969). See also

B. MANNING. supra note 4, at 1-15.7. For example, under the Internal Revenue Code of 1954 the portion of any distribution paid

out of a corporation's earnings and profits accumulated after 1913 and through the end of the year ofdistribution is included in the recipient's gross income. In the event the distribution is not out ofearnings and profits, the distribution is tax-free up to the amount of the shareholder's basis in theshares and thereafter is taxable as a gain from sale or exchange of the stock (i.e., generally as acapital gain). I.R.C. §8 301, 316. On the other hand, disproportionate repurchases by the corporationfrom shareholders of shares generally are treated as sales or exchanges of the shares, see I.R.C. §302.

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Statutory Restrictions on Corporate Distributions

come taxes have a direct interest in the aggregate amount of such distribu-tions. 8 In addition, significant differences in the type of tax typically im-posed on the two types of distribution-dividends are typically taxed asordinary income; share repurchases typically give rise to capital gains onthe excess received over basis 9-make it a matter of governmentalinterest how the funds are distributed. 10

Data on profits after taxes, after tax profits adjusted for inventory valu-ation and capital consumption effects, and dividends for all United States

The Treasury Department in 1975 offered a proposal by which personal and corporate incometaxes would be integrated. See [1975] 9 STAND. FED. TAX REP. (CCH) 6160, at 70,893-94. The sub-ject has since received intensive study. See M. BLUME, J. CROCKETT & S. FRIEND. FNANcIAL EFECrs OFCAPrTAL TAX R.roRmis (N.Y.U. Monograph Series in Finance and Economics 1978); STAFF OF THE

JoINT CommrrrEE ON TAXATION, 95TH CONG., IsT SEsS., TAX POuCv AND CAPrrAL FORMATON (Comm.Print 1977); UNrrEo STATES TREASURY DEPARTMENT, BLUEPRINTS FOR BASIC TAX REFORM ch. 3 (1977);Clark, The Morphogenesis of Subchapter C: An Essay in Statutory Evolution and Reform, 87 YALE L.J. 90 (1977); The Committee on Corporations of the Tax Section of the New York State Bar Associa-tion, Report on the Integration of Corporate and Individual Income Taxes, 31 TAX LAw. 37 (1977);Gabinet & Coffey, The Implications of the Economic Concepts of Income for Corporation-Share-holder Income Tax Systems, 27 CASE W. RFs. L. REv. 895 (1977); Litzenberger & Van Home, Elimi-nation of the Double Taxation of Dividends and Corporate Financial Policy, 33 J. FINANCE 737(1978); McLure, Integration of the Personal and Corporate Income Taxes: The Missing Element inRecent Tax Reform Proposals, 88 HARv. L. REv. 532 (1975); Nolan, Integration of Corporate andIndividual Income Taxes, 1978 S. CAL. TAX INsT. 899; Symposium, The Taxation of Income FromCorporate Shareholding, 28 NAT'L TAX J. 255 (1975); Wheeler & Gaffney, The Double Taxation ofCorporate-Source Income: Reality or Illusion?, 8 TAX ADviSRE 516 (1977); Wright, Crises Ahead:Challenges to America's Tax System, 29 OKLA. L. REv. 911 (1976).

8. In the case of distributions out of earnings and profits, dividends in tax parlance, the degree ofthe federal interest in the aggregate amount of corporate distributions depends on the relative amountsreceived by various types of taxpayers. Dividends over $100 received by individual shareholders areincluded in gross income. I.R.C. §§ 116, 301. An exception exists for distributions from corpora-tions qualifying under subchapter S. See I.R.C. §§ 1373, 1375. Dividends received by corporationsare included in gross income but are subject to an off-setting deduction of at least 85% and possibly asmuch as 100%. I.R.C. § 243. Dividends received by exempt organizations are generally not subjectto tax. I.R.C. § 501. See Blume, Crockett & Friend, Stockownership in the United States:Characteristics and Trends, in UNITED STATES DEPARTMENT OF COMMERCE. 54 SURVEY OF CURRENT Busi-Nmss 16, 20 (Nov. 1974) (table of dividends received by types of taxpayers in 1971). The Treasury'sinterest in the size of the aggregate amount is protected by the series of provisions imposing a penaltytax on unreasonable accumulations. I.R.C. §3 531-537.

The governmental revenue interest could be protected in the event of radical changes in distribu-tion patterns of corporations by increasing the corporate tax, by changing the unreasonable accumula-tion tax, or by imputing corporate income to shareholders.

9. SeeI.R.C. §§301,302,316.10. The federal government's interest in this respect undoubtedly led to the possible characteriza-

tion of periodic redemptions of stock as dividends to sellers of shares and to the remaining sharehold-ers. See I.R.C. 33 302(b)(2)(D), 305(c); 1969-3 C.B. 270-71, 519-20; Chirelstein, Optional Re-demptions and Optional Dividends: Taxing the Repurchase of Common Shares, 78 YALE L.J. 739,755-56 (1969).


corporations organized for profit for the years since 1968 appear below."

Adjusted Payout PayoutNet Profits Profits Dividends Percentage Percentage

Year (Billion $) (Billion $) (Billion $) Net Profits Adj. Profits

1968 46.2 46.5 21.9 47 471969 43.8 41.8 22.6 52 541970 37.0 33.4 22.9 62 691971 44.3 39.6 23.0 52 581972 54.6 50.5 24.6 45 491973 67.1 50.4 27.8 41 55

1974 74.5 31.2 31.0 41 991975 73.4 49.2 32.4 44 661976 92.1 63.3 35.8 39 571977 102.1 72.3 43.7 43 601978 118.1 75.6 49.3 42 65

Data on share repurchases of a smaller group of corporations for the sametimespan appear below. 12

11. These data are Department of Commerce estimates published in the Survey of Current

Business, See UNrrED STATES DEPARTMENT OF COMMERCE, 1977 BUSINES STATISTICS 7 (supplementto the SURVEY) [hereinafter 1977 BUSINESS STATISTICS 7]; UNITED STATES DEPARTMENT OF COMMERCE, 59

SURVEY OF CURRENT BUSINESS 13 (April 1979). Even for the corporations concerned, these figures donot represent the true aggregate of dividends paid as the series omits dividends paid to shareholderswho are not United States residents. The amount of dividends paid by all domestic corporations to

foreigners in 1971 has been estimated at 840 million dollars. Blume, Crockett & Friend, supra note

8, at 20.

Statistics of Income: Corporation Income Tax Returns, published annually by the Internal Revenue

Service, also provides estimates of the data presented in text. That series was not used in the text

above, as the most recent final data available relates to 1974 tax returns. In addition, the most recent

major study of corporate dividend policy used data prepared by the Department of Commerce and

thus trend analysis was facilitated by use of the Commerce data. J. BRITrAIN, CORORATE DIVIDEND

POLICY (1966).12. Standard & Poor's Annual Average of Daily Indexes appears in Standard & Poor's Corpora-

tion, Security Price Index Record 5 (1978). The share repurchase data are Securities and Exchange

Commission estimates for repurchases, calls and other retirements of stock. See 36 SEC STATISTICAL

BULLETIN 18 (1977). The series has not been published since that date because the SEC is considering

methodological changes. The estimates are all derived from announcements appearing in the finan-

cial press and statistical services and from data appearing in periodic reports filed by companies with

the SEC. The data include repurchases by public tender offers, open market transactions, and cash

payments in connection with liquidations, reorganizations, and mergers. Purchases of a corporation's

own stock for the purpose of servicing options and thrift plans are not included. The background

material also states that it is probable that many retirements of small companies are not included. Id.

at 17. Despite the importance of information on share repurchases as a matter of tax policy, there

appears to be no way of deriving better data from Internal Revenue Service statistics.

One author has reported data for 1954 to 1964 for repurchases by companies listed on the NewYork Stock Exchange. Guthart, More Companies Are Buying Back Their Stock, 43 HARV. BUS. REV.

40 (Mar.-Apr. 1965). Apparently these data are not published by the Exchange.

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Share Standard & Poor'sRepurchases Index of

Year (Billion $) 400 Industrials1968 5.5 107.51969 3.8 107.21970 2.7 91.31971 1.7 108.41972 2.4 121.81973 3.1 120.51974 3.6 92.91975 2.2 96.61976 2.7 114.31977 - 108.4

These data provide a number of insights as to the aggregate effects of cor-porate policy with respect to financial distributions: (a) the aggregateamount of dividends paid has increased in fairly regular, modest stepsover the years presented,13 despite more significant and at times divergentchanges in net profits and adjusted profits; (b) aggregate dividends paidhave increased at a faster rate over the period presented than the cost-of-living index; 14 (c) the proportion of profits adjusted for inflationary ef-fects on inventory valuation and capital consumption paid out as divi-dends has increased significantly in the late 1970's as compared with theproportion paid out during the late 1960's; 15 (d) changes in the volume ofshare repurchases during the years presented tend to be inversely relatedto changes in the level of the stock market averages during the followingyear; 16 and (e) share repurchases do not appear to be replacing dividendsas a means of distributing corporate assets. 17

13. Aggregate dividends have declined in only two years since 1947 (in 1951 and in 1958) andthen only by relatively small amounts. See 1977 BusiNEss STATISTIcs 7, supra note 11.

14. The average Consumer Price Index (base 1967) for the year 1968 was 104.2. The average for1978, 195.3, was 91.1 points higher than the 1968 average. See BUREAU OF LABOR STATIsncs, UNrrEDSTATES DEPARTiENr OF LABOR, 102 MONrHLY LABOR RaV. 93 (April 1979). Over the same period,dividends paid increased by 125%. Thus, dividends increased at an annual compound rate of 8.46%,as against a compound rate of increase of 6.48% for the Consumer Price Index.

Apparently some corporations have adopted an explicit goal of keeping the rate of dividend in-creases larger than increases in the Consumer Price Index. See Biel, Indexing Dividends, 122 FORBEs186 (Oct. 30, 1978) (discussing statements to that effect by the chairman of American Telephone &Telegraph Company).

15. The size of the increase in proportion becomes more evident when the proportions paid out in1966 (40%) and in 1967 (43%) are added to the figures in text. See 1977 BusiNEss STATISnCS 7, supranote 11.

16. Thus, if the repurchases for any year are compared with the Standard & Poor's average forthe following year, there is a correlation coefficient of - 0.47 between the two sets of data.

17. It is not clear the degree to which this effect may be attributed to the Revenue Act of 1969.See note 10 supra (authorities cited therein).

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The federal government may also be interested in the aggregate of cor-porate financial distributions because of the possible impact of suchdistributions on various macroeconomic policies.18 For example, volun-tary limitations on dividend increases were promulgated as part of theEconomic Stabilization Program that ended on April 30, 1974.19 Whilethe main purpose of this limitation appears to have been to prevent anexpansion of dividend income that would have been perceived as inequit-able in comparison to permissible increases in wages,20 it was alsoviewed as a means of providing funds for industrial expansion whichmight in turn ease inflationary pressures. 21 Presumably in the event ofeconomic recession, governmental policy would operate to encourage in-creased dividends as a means of increasing the income of recipient share-holders.

22

There may also be a governmental interest in encouraging distributionsby large corporations as a means of preventing further concentration ofindustry. 23 Some authors have argued that if funds are distributed toshareholders, they will decide where to reinvest such funds and may wellprefer investment in newer, smaller enterprises rather than reinvestmentin the declaring corporation. It has also been argued that profits generallyought to be distributed so that each corporate investment is subject to thejudgment of the marketplace as to its worthiness. 24 Although empirical

18. Brittain observes that the stability in the amount of aggregate dividends and the sluggishadjustment of dividends to changes in income acts as a stabilizing influence on the economy. J. BRrr-TAIN, supra note 11, at 212. See also D. RAY, ACCOUNTING AND BUSINESS FLUCrUATIONS 124-34 (1960).

19. See generally Droitsch, The Impact of The Economic Stabilization Program on BusinessFixed Investment, in 2 HISTORICAL WORKING PAPERS ON THE ECONOMIC STABILIZATION PROGRAM--AUGUST

15, 1971 TO APRIL 30, 1974, at 949-70 (1974). Great Britain recently abolished mandatory limita-tions on the amount of dividends corporations could pay to shareholders that had been in effect forseven years. Wall St. J., Aug. 1, 1979, at 23, col. 3.

20. See Hearings on H.R. 11309 Before the House Committee on Banking and Currency, 92dCong., 1st Sess., pt. 2, at 460 (1971) (testimony of Arthur Bums, Chairman of the Committee onInterest and Dividends).

21. See Droitsch, supra note 19, at 984; Hearings on H.R. 2099 and H.R. 6168 Before theHouse Committee on Banking and Currency, 93d Cong., 1st Sess. 587 (1973) (testimony of ArthurBums).

22. Cf. R. PAUL, TAXATION IN ThE UNITED STATES 190-98, 213-20 (1954) (discussion of the Un-distributed Profits Act, enacted in 1936 and repealed in 1939).

23. See A. BERLE, THE 20rH CENTURY CAPITALIST REVOLUTION 35-42 (1954); M. FRIEDMAN, CAPI-

TALISM AND FREEDOM 130 (1962). John Kenneth Galbraith argues that control over retained earningsinsulates the technostructure of a corporation-all who participate in group decisionmaking-fromoutside scrutiny. J. GALBRArrH. THE NEW INDUSTRIAL STATE 81 (1967).

24. Berle, Modern Functions of the Corporate System, 62 COLUM. L. REv. 433, 441-42 (1962);Sabatino, The Responsible Corporation, 25 Am. J. ECON. & Soc. 255, 262 (1962).

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studies have cast doubt on both arguments, 25 occasional statements ofgovernmental policy are still based on them. 26

B. Interests in Corporate Dividend Policy

1. Common shareholders

a. Publicly held corporations

It is generally assumed that common shareholders seek to maximizeiheir wealth and therefore desire corporate policies that maximize thevalue of the enterprise and its securities. 27 A critical issue in determiningsuch policies is whether the level of a corporation's dividend payout ratio(i.e., dividends compared to earnings) has any long-run effect upon thevalue of a corporation's shares. 28 Despite intense study for a number ofyears, the issue has not yet been definitively resolved.

A clear-cut answer can be obtained if one assumes that perfect capitalmarkets exist in which all investors are rational, information is availableto all at no cost, transactions are consummated instantaneously and with-out cost, new securities may be issued by a corporation without cost, notax differential between dividends and capital gains exists, each corpora-tion has a stated investment policy, and every investor is certain as to thefuture investments and profits of the corporation. 29 Under these condi-

25. Thus, one study concluded that large corporations have not altered their dividend policies inthe direction of more retentions, as was predicted under the Berle thesis. Lintner, The Financing ofCorporations, in THE CORPORATION IN MODERN SOCIETY 166, 183-90 (E. Mason ed. 1959). On theother hand, a number of studies have indicated that larger firms in concentrated industries are moreprofitable than smaller firms. See Weston, Implications of Recent Research for the Structural Ap-proach to Oligopoly, 41 ANTrrRusT L.J. 623 (1972) (review of empirical studies). Even if the divi-dend payout ratios are identical for large and small firms within an industry, it would seem that thelarge retentions relative to assets in the larger firms would contribute to further concentration.Lintner's partial answer is that large non-financial corporations have not moved to a position of domi-nance over the financial sector. Lintner, supra, at 177.

The evidence reviewed by Lintner and by Mendelson, Payout Policy and Resource Allocation, 116U. PA. L. Rav. 377 (1968), is contrary to the second argument in text. See also notes 73-86 infra(authorities cited therein).

26. See [1975] 9 STAND. FED. TAx REP. (CCH) 6160, at 70,892, 70,896 (Treasury Departmentstatements).

27. See, e.g., E. SOLOMON, THE THEORY OF FINANCIAL MANAGEMENT 9 (1963). As to the possiblerelationship between share price maximization and profit maximization, see Bird, A Reappraisal ofthe Share Price Maximisation Criterion, 5 AccOUNTING & Bus. Ras. 127 (1974).

28. See, e.g., J. VAN HORNE, FINANCIAL MANAGEMENT AND PouCY 278-79 (4th ed. 1977).29. The assumptions are those of the seminal work on the effects of dividend policy on the value

of a corporation. Miller & Modigliani, Dividend Policy, Growth, and the Valuation of Shares, 34 J.BUSINEss 411, 412 (1961). They define "perfect capital markets" as those in which no buyer or sellerof securities is large enough to have an appreciable impact on price and in which securities are infin-itely divisible. "Rational behavior" is defined as preferring more wealth to less and being indifferentto the form of increase in wealth. Id.

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tions, shareholder wealth will not be affected by the dividend payoutdecision;30 regardless of whether the corporation decides to finance its in-vestments by retaining earnings or by selling new shares after it has dis-tributed its earnings as dividends, total shareholder wealth will be thesame. 31

The effect of relaxing the perfect world assumptions is the subject ofsome dispute. The framers of the perfect world model argue that even ifinvestors are uncertain as to the future investments and profits of the cor-poration, dividend policy will remain irrelevant as long as the other as-sumptions are unchanged because investors have no reason to differenti-ate between corporations with equal business risk on the basis of theirretention ratios. 32 A number of other studies indicate, however, thatchanges in dividends have an effect upon share prices, apparently becausethe changes communicate unique information to investors about manage-ment's perception of the corporation's future profitability. 33 Other au-thors argue that investors' risk aversion will lead them to prefer currentdividends for two different reasons. The first line of analysis notes that

30. Even the principal proponent of the view that dividend payout affects valuations agrees thatthe level of payout is irrelevant under the stated assumptions. See Gordon, Optimal Investment andFinancing Policy, 18 J. FINANCE 264, 265 (1963).

31. The Miller and Modigliani thesis also leads to the conclusion that shareholder wealth is unaf-fected by the corporation's decision to finance investment opportunities through the use of debt. SeeJ. VAN HORNE, supra note 28, at 281. See also V. BRUDNEY & M. CHIRELSTEIN, CASES AND MATERIALS

ON CORPORATE FINANCE 438-42 (2d ed. 1979) (providing examples demonstrating that under the statedassumptions the total value of the corporation will be the same regardless of how investments arefinanced).

32. See Miller & Modigliani, supra note 29, at 428-29. Lewellen provides examples that dem-onstrate that if any differences in share prices developed between firms with the same business risk,but pursuing different retention policies, arbitrage would operate to equalize the prices. W. LEwa-LEN, THE COST OF CAPITAL 54-57 (1969).

33. A number of empirical studies have concluded that dividend announcements conveyinformation about future earning prospects that could not be obtained from past time series of futureearnings. See Boim, The Effects of Consolidated Edison's 1974 Dividend Omission Upon the Com-mon Stock Returns of the Utilities Industry, I CHICAGO MBA 85 (1977); Fama, Fisher, Jensen & Roll,The Adjustment of Stock Prices to New Information, 10 INT'L ECON. REv. 1 (1969); Griffin, Competi-tive Information in the Stock Market: An Empirical Study of Earnings, Dividends and Analysts' Fore-casts, 31 J. FINANCE 631 (1976); Gonedes, Corporate Signaling, External Accounting and CapitalMarket Equilibrium: Evidence on Dividends, Income and Extraordinary Items, 16 AccouNTINGRESEARCH 26 (1978); Laub, On the Informational Content of Dividends, 49 J. Bus. 73 (1976); Pettit,Dividend Announcements, Security Performance and Capital Market Efficiency, 27 J. FINANCE 993(1972). However, Watts concludes from an extended study that while there is a positive relationshipbetween future earnings changes and current unexpected dividend changes, the average absolute sizeof earnings changes conveyed by unexpected dividend change is so small as to be trivial. Watts, TheInformation Content of Dividends, 46 J. Bus. 191 (1973). See also Ang, Dividend Policy: Informa-tional Content or Partial Adjustment?, 57 REv. EcON. & STATISTICS 65 (1975); Brown, Finn & Han-cock, Dividend Changes, Earnings Reports, and Share Prices: Some Australian Findings, 2 AuSTRA.LIAN J. MANAGEMENT 127 (1977). For additional analysis of,the various studies, see Pettit, The Impactof Dividends and Earnings Announcements: A Reconciliation, 49 J. Bus. 86 (1976); Sunder,

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for many corporations dividends per share are stable over time as com-pared to the corporation's share price. Thus, it is argued that a risk averseinvestor will prefer a stable source of income to a fluctuating source. 34

The second line of analysis argues that distant events are perceived byinvestors to present greater risk than near-future events, and that as aresult a reduction of current dividends, even if connected with the pros-pect of increased future dividends, will reduce the corporation's shareprice because of the perceived increase in risk. 35

Relaxation of the other perfect world assumptions leads to distinctpreferences by various classes of investors for dividends or retained earn-ings. Once tax effects are recognized, individual investors generallyshould prefer capital gains (and hence retention of earnings) rather thandividends. 36 Corporate shareholders generally should prefer dividends. 37

The costs that a corporation would incur in connection with a new offer-

Discussion, 31 J. FINANCE 680 (1976); Watts, Comments on "On the Informationa? Content of Divi-dends," 49 J. Bus. 81 (1976); Watts, Comments on "The Impact of Dividends and Earnings An-nouncements: A Reconciliation," 49 J. Bus. 97 (1976).

Keane argues that the disclosure requirements imposed by the SEC on new issues of securitiesprovide significantly more information to investors than is available if the company decides to fi-nance a particular investment by means of retained earnings. Keane, Dividends and the Resolution ofUncertainty, 1 J. Bus. FINANCE & AccouNTnNG 389 (1974). Thus, he concludes that the payment of

dividends and the resulting issue of new securities results in less uncertainty in the minds of investors.Miller and Modigliani argue that the informational content of dividends does not affect the

irrelevance thesis as the share price still reflects future earnings of the corporation as announced bythe dividend change. Miller & Modigliani, supra note 29, at 430.

34. R. HIGGINS. FINANCIAL MANAGEMENT 226 (1977). Lintner suggests that stable dividends may

contribute to volatile stock prices and thus that total return is the more important variable. Lintner,Dividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to Corporations, 44 REv.ECON. & STATISTICS 243 (1962).

35. Gordon, Optimal Investment and Financing Policy, 18 J. FINANCE 264, 265-66 (1963). Anumber of writers have taken issue with Gordon on this point, arguing that risk-averse investors couldobtain the desired current return by selling a portion of their shares each period. See Brennan, A Noteon Dividend Irrelevance and the Gordon Valuation Model, 26 J. FINANCE 1115 (1971); Higgins, Divi-dend Policy and Increasing Discount Rates: A Clarification, 7 J. FINANCIAL & QUANTITATIVE ANALYSIS

1757 (1972); Krainer, A Pedagogic Note on Dividend Policy, 6 J. FINANCIAL & QUANTrrATIVE ANALY-sis 1147 (1971). Another scholar argues that high pay-out companies must reduce future profits bythe cost of acquiring capital needed for investments and thus that shareholders will receive lowerdividends in the future than they would have had the current payout ratio been lower. Soter, TheDividend Controversy-What It Means for Corporate Policy, 47 FINANCIAL ExactmnVE 38-39 (May1979).

36. A taxpayer may deduct 60% of his capital gains. I.R.C. § 1202. Thus, in effect, capital gainsare taxed at approximately 40% of the rate applied to dividends in excess of $100. Because of thedividend exclusion, individual shareholders should prefer dividends to capital gains when the amountof dividends received is less than $100. I.R.C. §§ 116, 301. One commentator notes that if the share-holder has no need to consume the return from the stock currently, there is also a significant taxadvantage in retention of earnings because it allows shareholders to defer paying taxes until later saleof the stock. H. BxmMAN, DECISION MAKING AND PLANNING FOR THE CORPORATE TREAsuRER 127-32(1977).

37. Corporations receiving dividends from domestic corporations are allowed a deduction of at


ing of shares should cause shareholders generally to prefer that the corpo-ration retain earnings rather than distribute them and finance projects withthe sale of new shares. This preference will be quite strong for sharehold-ers in any corporation in which access to capital markets is impossible orin which transaction costs would be a large portion of the offering price. 38

When the costs of transferring shares are considered, shareholders willhave varying preferences depending on the particular shareholder's needfor current funds and the size of any potential dividend. 39 A shareholderwho desires current income must, in the face of a corporate decision toretain all earnings, sell shares and pay the brokerage fee on such sale,which may be a sizeable percentage of a small sale. On the other hand, ashareholder who does not wish current income must, absent a dividendreinvestment program, pay brokerage fees to purchase shares with anydividend received. 40 Shareholders in corporations with substantial debthave a preference toward distribution of the largest dividend permissibleunder the terms of any contractual dividend restrictions. 41 Finally, inves-tors restricted by statutes to shares with a long record of continuous divi-dend payments42 and others limited in their ability to use capital gainsprefer dividends. 43

least 85% of the amount received. I.R.C. § 243(a)(1). On the other hand, net capital gains receivedby most corporations are subject to a tax of 28%. I.R.C. § 1201 (a).

Tax-exempt organizations should generally be indifferent to the form of return, absent legal restric-tions on their ability to use capital gains. See text accompanying note 43 infra. However, in certainsituations private foundations may have a distinct preference for capital gains. See .R.C. § 4942.

The preference of a trust for one type of return or the other is a function of the terms of the trust, thebeneficiaries' tax brackets, and the trust's tax bracket. See .R.C. §§ 651-662.

38. R. HIGGINS, supra note 34, at 228-29; J. MAO, CORPORATE FINANCIAL DECISIONS 328-31(1976). Lintner notes that in addition to the underwriting, accounting and legal fees involved, corpo-rations making new offerings of stock must price the new offering below the current market price inorder to attract investors to the stock, thus increasing the cost of the offering. Lintner. supra note 34,at 257.

39. J. VAN HORNE, supra note 28, at 288-89.40. The increasing use of dividend reinvestment plans is thought to produce a net preference for

dividends. Id. at 289. For a discussion of dividend reinvestment programs, see P. Davey, DividendReinvestment Programs, in CONFERENCE BOARD REPORT No. 699, at 4 (1976); Fredman, Nichols &Reilly, Dividend Reinvestment Innovations, 95 BANKERS MONTHLY MAGAZINE 18 (Dec. 1978); andPettway & Malone, Automatic Dividend Reinvestment Plans of Nonfinancial Corporations, 2 FINAN.

CIAL MANAGEMENT II (Winter 1973).41. See Black & Scholes, Tile Pricing of Options and Corporate Liabilities, 81 J. POLITICAL

ECONOMY 637, 651 (1973); B. MANNING, LEGAL CAPITAL 8-12 (1977).42. J. WESTON & E. BRIGHAM, MANAGERIAL FINANCE 693 (4th ed. 1975) (discussing the criteria for

legal lists of securities in which mutual savings banks, pension funds, insurance companies, andother fiduciary institutions are permitted to invest).

43. See, e.g., W. CARY & C. BRIGHT, THE DEVELOPING LAW OF ENDOWMENT FUNDS 2 (1974) (dis-cussing the widely held view that the realized gains of endowment funds of educational institutionsmust be treated as principal and thus not be currently expended).

Vol. 55:359, 1980


A corporation attempting to maximize shareholder wealth presumablywould empirically determine the balance of shareholder preferences ei-ther directly or through a study of the relationship between share priceand dividend payout for a sample of similar companies. 44 It would thenhave to determine whether there is a generally preferred rate of payout forcorporations, which if adopted by the subject corporation would increasethe value of its shares. A number of empirical studies have been made onthis question but they have produced conflicting results. 45 The scope of

44. J. VAN HORNE, supra note 28, at 289-92. Miller and Modigliani argue that corporations willtend to attract "clienteles" of shareholders who prefer their particular payout ratios and that the irre-levance proposition will continue to apply unless the distribution of investor preferences for a particu-lar corporation is heavily concentrated at either of the extreme ends of the payout scale. Miller &Modigliani, supra note 29, at 431. Two scholars have found results consistent with a clientele effect.Black & Scholes, The Effects of Dividend Policy on Common Stock Prices and Returns, I J.FINANCIAL ECONOMICS I (Mar. 1974). See also R. BREALEY, SECURITY PRICES IN A COMPETITIVE MARKET

8-11 (1971) (review of empirical studies, most of which show a significant tendency for high-in-come groups to prefer low-payout stocks). The data presented by Blume, Crockett & Friend, supranote 8, at 30, are also generally consistent with a "clientele" effect. Those data indicated taxpayersin higher adjusted gross income brackets tended to invest a larger proportion of their stockholdings intypically low-payout over-the-counter and miscellaneous (unlisted) stocks than did taxpayers withlower adjusted gross income brackets. The pattern did not apply to taxpayers in the lowest grossincome bracket (under $5000) as a significant proportion of their stockholdings were in miscella-neous (unlisted) stocks. On the other hand, another study concluded from a study of stocks held by2500 brokerage firm customers that there was not "much evidence [in the data] to support the notionthat an important dividend-tax-clientele effect is in fact present." Lewellen, Stanley, Lease & Schlar-baum, Some Direct Evidence on the Dividend Clientele Phenomenon, 33 J. FINANCE 1385, 1395(1978).

45. See, e.g., Arditi, Risk and the Required Return in Equity, 22 J. FINANCE 19 (1967) ("inves-tors like high dividend-payouts"); Bar-Yosef & Kolodny, Dividend Policy and Capital Market The-ory, 65 REV. EcoN. & STATISTICS 181 (1976) (concluding that investors have a net preference forreceiving their return in the form of dividends); Brigham & Gordon, Leverage, Dividend Policy, andthe Cost of Capital, 23 J. FINANCE 85 (1968) (the rate of return investors require increases with thecorporation's retention rate); Diamond, Earnings Distribution and the Evaluation of Shares, 2 J. Fi.NANCE & QuANrrATIvE ANALYSIS 15 (1967) (market weighted dividends slightly more than retentions);Gordon, Dividends, Earnings, and Stock Prices, 41 REV. ECON. & STATISTIcs 99 (1959) (a dollar ofdividends is generally worth more to investors than a dollar of retained earnings); Van Home &McDonald, Dividend Policy and New Equity Financing, 26 J. FINANCE 507 (1971) (concluding thatinvestors have a net preference for receiving their return in the form of dividends). In addition, an-other study found some evidence that dividends are valued more highly than retained earnings in low-growth companies, but the opposite was true for high-growth firms. Friend & Puckett, Dividend andStock Prices, 54 Am. ECON. REV. 656 (1964). On the other hand, a recent study found indirect evi-dence supporting the notion that for given profits dividend payout policy had no effect on marketvalue. Modigliani & Cohn, Inflation, Rational Valuation and the Market, FINANCIAL ANALYSTS J. 24,42 (1979). In addition, Black and Scholes found evidence suggesting there is no excess demand forone dividend yield over another, Black & Scholes, supra note 44, at 1&-19; and another scholarconcluded that dividends appear to have no influence on share prices in the electric utility industry.Higgins, Growth, Dividend Policy and Capital Costs in the Electrical Utility Industry, 29 J. FINANCE1189 (1974). Accord, Miller & Modigliani, Some Estimates of the Cost of Capital to the ElectricUtility Industry, 56 Am. ECON. REV. 333 (1966). See also R. BRLEY, supra note 44, at 15-21 (re-view of earlier studies); Frost, Dividend Policy and Capital Market Theory: A Comment, 60 REV.EcoN. & STATISTICS 475 (1978).

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these studies and their conflicting results suggest, however, that if excessdemand for a particular dividend rate exists, it is unlikely that such de-mand is large or would be permanent. Thus, it would seem inappropriatefor any corporation to attempt to shift from a payout policy determinedoptimal for its particular situation.

Corporations also appear to behave in a manner that is consistent with abelief that stable dividend payments will cause investors to place a highervalue on the company's stock. 46 A number of studies47 indicate that cor-porations adopt a long run target payout ratio, and that in any given yearthis payout ratio is applied to some measure of current performance 48 to

46. See, e.g., L. SCHALL & C. HALEY, INTRODUCTION TO FINANCIAL MANAGEMENT 380-81 (1977); J.WESTON & E. BRIGHAM, MANAGERIAL FINANCE 691-92 (4th ed. 1975). Accord, M. WRIGHT, THE DIREC-

TORS GUIDE To ACCOUNTING AND FINANCE 67 (1976) (making the same observation about British com-panies). See also data accompanying note I I supra.

47. See J. BRITrAIN, CORPORATE DIVIDEND POLICY 125-70 (1966): Darling, The Influence of Ex-pectations and Liquidity on Dividend Policy, 65 J. POLITICAL ECONOMY 209 (1962); Fama & Babiak.Dividend Policy: An Empirical Analysis, 63 Am,. STATISTICAL A.J. 1132 (1968). Grabowski &Mueller, Managerial and Stockholder Welfare Models of Firm Expenditures, 54 REV. ECON. & STA-

TISTICS 9 (1972); Linter, Distribution of Incomes of Corporations Among Dividends, Retained Earn-ings, and Taxes. 46 AM. ECON. REV. 97 (1956); Ryan, Dividend Policy and Market Valuation inBritish Industr., I J. Bus. FINANCE & ACCOUNTING 415 (1974); Turnovsky, The Allocation of Corpo-rate Profits Between Dividends and Retained Earnings, 49 REV. ECON. & STATISTICS 583 (1967). Allof these studies use regression models to determine relationships between dividends and measures ofcurrent performance for large numbers of corporations. See also Smith, Increasing StreamHypothesis of Corporate Dividend Policy, 14 CAL. MANAGEMENT REV. 56 (1971) (presenting fre-quency analysis of dividend changes and earnings changes); Thompson & Walsh. Companies StressDividend Consistency, 25 MANAGEMENT REC. 30 (1963) (presenting results of a survey of manufactur-ing companies).

48. See, e.g., J. BRITTAIN, supra note 47 (uses net income plus depreciation allowances); Dar-ling, supra note 47 (uses current earnings, past earnings, the rate of amortization recovery, shifts inanticipations of future earnings, and persistent shifts in the level of sales); Grabowski & Mueller,supra note 47 (uses profits and cash flow); Lintner, supra note 47 (uses current earnings). Fama andBabiak tested a number of models and concluded that net income provides a better measure of profitsthan either cash flow or net income and depreciation as separate variables in the model. Fama &Babiak, supra note 47.

Other studies have found other significant relationships between dividends and other financialvariables. See Dhymes and Kurz, On the Dividend Policy of Electric Utilities, 46 REv. ECON OF

STATISTICS 76 (1964) (significant relationship between the dividend policy of electric utilities and ac-tual and anticipated levels of investment). Dhrymes and Kurz later found a significant degree of inter-dependence between the investment and dividend decisions, with investment being restrained by di-vidends, particularly in years of expansion, and dividends being restrained by the demand for fundsfor investment. Dhrymes & Kurz, Investment Dividend and External Finance Behavior of Firms, inDETERMINANTS OF INVESTMENT BEHAVIOR 427 (R. Ferber ed. 1967). One commentator found thatdividends vary positively with earnings and negatively with investment. Higgins, The CorporateDividend-Saving Decision, 7 J. FINANCIAL & QUANTITATIVE ANALYSIS 1527 (1972). Herendeen found avery stable relationship between the dividends paid by all manufacturing corporations during theyears 1958 to 1970 and the book value of the corporation's equity. J. HERENDEEN, THE ECONOMICS OF

THE CORPORATE ECONOMIY 207-22 (1975). He argues that the actual behavior of managers is to pay arelatively fixed rate of return on equity irrespective of the corporation's current profit position. He

370


obtain the target levels for dividends. When current performance isimproved over that of prior periods, dividends will be permitted to in-crease to the target level only if it is felt that the improved performancewill be maintained. When current performance has declined compared tothat of prior periods, the lag in the dividend adjustment is longer as com-panies appear reluctant to cut the current dividend. 49 No comprehensiveempirical study has yet demonstrated that a policy of dividend stabilitywill lead to higher stock prices than those produced by other dividend pol-icies, 50 but such a policy does appear to satisfy a number of the investorpreferences previously discussed. 51

says that this behavior is consistent with the view that corporate managers treat shareholders andbondholders similarly, and pay each group only what is necessary to insure an adequate supply offunds to the enterprise. Id. at 215-16.

49. See, e.g., Brittain, The Tax Structure and Corporate Dividend Policy, 54 AM. EcoN. REV.272, 273 (1964); Lintner, supra note 47, at 101, 107.

The pursuit by corporations of stable dividend policies appears to conflict with the suggestion thatdividends should be a passive residual quantity to be determined after acceptable investment opportu-nities have been financed. Two commentators argue, however, that most corporations follow asmoothed residual dividend policy whereby yearly dividends are determined so that over the long runthey will be relatively constant and will equal earnings less investment. L. SCHALL & C. HALEY, supranote 46, at 384-87. Higgins notes that a policy of stable dividends either requires management tomaintain ample financial reserves (i.e., liquid assets and unused borrowing capacity) to keep the divi-dend smooth in the face of changing earnings and investments, to be able to project cash flow withconsiderable accuracy, or to be able to postpone investment projects. R. HIGGINS, supra note 34, at237-38.

50. Indeed, one study concludes that a policy of dividend stability is inconsistent with both max-imizing price per share and maximizing utility to the shareholder. See Ezzel, The Effect of DividendInstability on the Market Price of Common Stock (unpublished dissertation, Pennsylvania State Uni-versity, 1970), discussed in J. HE-Nar, supra note 48, at 212 (1975). Another study concludesthat the predominance of stable dividend policy in practice must be interpreted to be a result of thepreference of management rather than market forces. See Mantripragad, Stable Dividends and SharePrices, 27 J. FINANcE 951 (1972) (dissertation summary).

51. Schall and Haley present three groups of investors who may prefer stable dollar dividends: (1)investors who view dividends as a source of funds to meet current living expenses; (2) investors whodesire to infer from changes in dividend payouts that management perceives significant changes inthe corporation's prospects; and (3) investors required to invest in shares with a long history ofconsistent dividends. L. ScHALL. & C. HALEY, supra note 46, at 382. For a prominent example ofinvestor reaction to a change in dividend pay-out rates, see Loomis, A Case for Dropping Dividends,77 FoRT NE 181 (June 15, 1968) (discussing the response of General Public Utilities Corporationshareholders to a proposed discontinuation of dividends for the purpose of financing capital expendi-tures).

Other authors argue that dividend stability is the product of management's desire to prevent scru-tiny of management decisions and thus, indirectly, of management's desire to retain control. SeeSmith, Corporate Saving Behavior, 29 CANADIAN J. oF EcoN. & POL. Sci. 297 (1963). It has also beensuggested that managers invest in projects that may enhance the corporation's size or growth, ratherthan share price. See ORGANIZATION FOR ECONOMIC CO-OPERATION AND DEvELoPMENT, THEORETICAL AND

EMPIRICAL AsPECrs OF CORPORATE TAXATION 31 (1974). As to the possibility that the goals of corporatemanagers diverge from maximization of the value of the enterprise, see text accompanying note 72infra.


b. Closely held corporations

The dividend policy of closely held corporations generally reflects thepreferences of the shareholders in the group controlling the corporation.5 2

Frequently the aggregate preferences of members of the controlling groupare so strongly in favor of retention that the corporation may retainearnings beyond its reasonable business needs. 53 On such occasions, twotypes of legal controls may cause the corporation to distribute more fundsthan its controlling shareholders desire. The more important of these con-trols is the penalty tax on unreasonable accumulations of earnings andprofits imposed by the Internal Revenue Code. 54 The second control, astate court action to compel the corporation to distribute funds inequitablywithheld, so seldom succeeds that it is not a major determinant in dividenddistributions. 55 On the other hand, the controlling group may attempt tomake distributions that are excessive and preferential by means of largecompensation payments to members of the group. 56 Such payments maybe limited by controls that are analogous to those mentioned above: theInternal Revenue Code allows the deduction of only a reasonable allow-

52. O'Neal states that: "the pressure normally on directors in a publicly held corporation to paysufficient dividends to maintain a favorable market in its securities and keep shareholders-electorshappy is absent in a close corporation whose shares are not traded and whose directors and officersusually are also its controlling shareholders." 2 F. O'NEAL, CLOSE CORPORATIONS § 8.08, at 59(1971).

53. Retention of earnings in such situations often reflects the desire on the part of controllinggroup to avoid federal income taxes on distributions or to squeeze minority shareholders out of thecorporation. The latter purpose may be combined with a desire to produce tax consequences oppositeto those generally sought; thus, a majority shareholder may put added pressure on a minority share-holder by withholding dividends in a subchapter S corporation (with the effect that the minorityshareholder is taxed on income not realized in cash).

On occasion, the controlling group may desire to retain current earnings because of perceived busi-ness needs for the distant future. The group, in weighing the possibilities of financing of such futurebusiness opportunities, may conclude that their ownership interest would be diluted by later sales ofstock and thus that earnings must be accumulated for the future opportunities to prevent such loss ofcontrol. See J. VAN HORNE, supra note 28, at 304.

54. I.R.C. §§ 531-537. The penalty tax may run as high as 38.5% of the corporation's accumu-lated taxable income (determined after deduction of the corporation's regular income taxes). I.R.C. §531.

The courts currently disagree on whether the accumulated earnings tax applies to publicly heldcorporations. Compare Golconda Mining Corp. v. Commissioner, 507 F.2d 594 (9th Cir. 1974),with Alphatype Corp. v. United States, all Ct. Cl. 345 (1976).

55. See 2 F. O'NEAL, supra note 52, §8.08, at 59-60.56. The motives for such payments are analogous to those noted earlier: to avoid federal income

taxes on the corporation or to squeeze minority shareholders out of the corporation. See note 53 su-pra.

On other occasions, the controlling group may cause the corporation to adopt a higher dividendpayout ratio than is warranted by business needs with the hope of warding off potential take-overattempts. See J. VAN HORNE, supra note 28, at 304. One of the more common defensive responses toa tender offer is for the target company to raise its dividend. E. ARANOW & H. EINHORN, TENDEROFFERS FOR CORPORATE CONTROL 245 (1973).

372


ance for compensation for personal services; 57 and state courts occasion-ally find that the compensation was unreasonable. 58

2. Senior security holders

Senior securities are here defined to include those instruments issuedby a corporation that possess a claim upon the corporation's income, andupon the corporation's assets in the event of financial difficulty or liqui-dation, prior to the claims of the holders of the corporation's commonstock. 59 To acquire these priorities, holders of senior securities often mustinvest for at least an intermediate term of years, accept a fixed claim onincome and assets on liquidation, and surrender the right to participate inthe control of the corporation. 60 By virtue of these limitations, the riskperceived by investors concerning the ability of the corporation toproduce sufficient cash to pay the annual returns on the securitiesthroughout their life, and to maintain assets that even in the event ofadversity will be at least equal in value to the securities' liquidationpreference, is paramount in the valuation of the securities. 61 These factors

57. I.R.C. §162(a)(1).58. See, e.g., Wilderman v. Wilderman, 315 A.2d 610 (Del. Ch. 1974). See generally 2 F.

O'NEAL, supra note 52, § 8.12.59. See, e.g., W. CARY, CASES AND MATERIALS ON CORPORATIONS 1177-78 (4th ed. 1969). While

the term is intended to include both interest-bearing debt instruments and preferred shares, this sec-tion focuses primarily on debt instruments because of their much larger relative importance in seniorfinancing. For an analysis of the tax and other factors leading to the decline in the use of preferredshares in financing and suggestions as to when preferred shares may nevertheless be the best financ-ing alternative available, see Donaldson, In Defense of Preferred Stock, 40 HARV. Bus. REV. 123(July-Aug. 1962). See also J. MAO, CORPORATE FINANCIAL DECISIONS 434-43 (1976); Elsaid, Non-convertible Preferred Stock As a Financing Instrument 1950-1965: Comment, 24 J. FINANCE 939(1969); Fischer & Wilt, Non-convertible Preferred Stock As a Financing Instrument 1950-1965, 23J. FINANCE 611 (1968).

60. See, e.g., W. CARY, supra note 59, at 1182-83. On occasion, a senior security (here morelikely preferred shares) may be entitled to participate beyond a fixed amount in the corporation'sincome or assets on liquidation. Id. at 1183. And senior securities, including debt instruments insome states, may vote on the election of directors of the corporation. D. HEwrrz, BUSINESS PLANNING291-92 (1966).

61. See, e.g., R. HIGGINS, supra note 34, at 266 ("an inverse relation exists between the qualityand magnitude of a security's claim of firm income and assets [and its return]"); J. WESTON & E.BRIGHAM, supra note 46, at 439-41. See also A. COHAN, YIELDS ON CORPORATE DEBT DIRECTLY PLACED

29-33 (1967) (discussion of the process by which large lenders determine the quality of and securityfor the critical promises in a long-term debt instrument). In assessing the quality of the promises,Cohan states that lenders examine the ratio of a five-year weighted average of earnings before interestand taxes to the pro-forma interest and factors that measure growth in and the variability of that ratio.Lenders then attempt to determine what would happen to any given loan if a recession occurred andwhat recourse would be available if such a loan did default by analyzing the ratio of working capitalto long-term debt, the ratio of long-term debt to total capital, and the lien position of the particularsecurity. Accord, Donaldson, New Framework for Corporate Debt Policy, 40 HARv. Bus. REv. 117(Mar.-Apr. 1962).

373


might seem to translate into a very distinct preference by senior securityholders for retention within the corporation of all earnings in excess ofamounts necesary to pay the annual return upon the senior securitiesthemselves.62 But the strength of this preference appears to vary withinvestor perceptions concerning the risk presented by the particular seniorsecurity. For example, a survey of dividend restrictions appearing in longterm debt instruments indicates that the most common covenant limits theamount of dividends to, and repurchases of shares from, shareholders tothe sum of the net earnings of the corporation accumulated from the dateof issue of the securities to the date of payment, and the proceeds from thesale of stock after the issue date. 63 This covenant presumably reflectsinvestor satisfaction at the time of investment with the coverage of thecurrent return and security for eventual repayment provided by the corpo-ration's current level of operations and assets. Yet one can easily hy-pothesize a situation in which the passage of time and inflation wouldcause holders of senior securities to prefer that the corporation retainearnings distributable under such a covenant.64

62. See Black & Scholes, The Pricing of Options and Corporate Liabilities, 81 J. POLrTCAL

ECONOMY 637, 651 (1973).63. The survey examined the information presented on the capital structure of 100 corporations

incorporated in the United States which were selected at random from the 1977 edition of Moody'sIndustrial Manual (the Manual includes all industrial companies listed on the New York StockExchange, the American Stock Exchange, and regional stock exchanges). Of the 100 corporationsexamined, two had no long-term debt; and 12 had long-term debt but had no restrictions on cashdistributions to shareholders. Of the remaining 86 corporations, 77 had a restriction of the type dis-cussed in text above. Fifty-six of the 77 corporations had only that restriction as the controlling cov-enant on dividends. (Some of the 56 permitted debt converted into stock to be included as shareproceeds and others permitted a fixed dollar amount in addition to the basic earnings plus proceedsfrom shares formula.) In the 21 corporations imposing additional restrictions beyond the text for-mula, the most common additional covenants were requirements that a stated level of working capitalbe maintained (17 corporations) or that a specified level of shareholder equity be maintained (sixcorporations). Two of the 86 corporations had a prohibition against cash distributions toshareholders. The remaining seven of the 86 corporations imposed some or all of the following re-strictions: a requirement that a stated level of working capital be maintained (3); that a specified cur-rent ratio be maintained (3); that a specified level of shareholder equity be maintained (2); that aspecified equity to debt ratio be maintained (1); and a limitation of dividends paid to the lesser of thecurrent year's income or a stated amount (1).

A survey of 25 corporations listed in Moody's Industrial Manual that had preferred shares out-standing indicated that most preferred stock agreements apparently do not impose restrictions on thecorporation's ability to distribute cash or property to shareholders. Where restrictions on dividendswere present, their terms varied from the pattern above only to make specific reference to preservingnet assets in the corporation equal the preferred shares' liquidation preference.

For a general discussion of the drafting of restrictions on dividends for debt instruments, seeAMERICAN BAR FOUNDATION, CORPORATE DEBT FINANCING PROJECT, COMMENTARIES ON MODEL DEBENTURE

INDENTURE PROVISIONS §§ 10-12 (1971).64. For example, one can hypothesize a small automobile manufacturer in need of large-scale

retooling in a time of drastically inflated costs. The availability of accumulated accounting earnings(since the issue date) in such a situation would appear irrelevant.


3. Trade creditors

Trade creditors typically provide the corporation with goods and ser-vices on terms that require payment within a relatively short period oftime. 65 In the event of liquidation of the corporation in straight bank-ruptcy, they, as unsecured creditors, are entitled to payment from the cor-poration's assets remaining after secured creditors and creditors withpriority are satisfied. 66 Because of the risk of loss in the event of defaultassociated with their subordinate status, 67 and because of the costs anddelays associated with default proceedings, 68 trade creditors desire thatthe dividend policy adopted by any corporation not impinge upon the cor-

65. Depending on the industry, the credit period may vary from 30 to 90 days. See T. BECKMAN &R. FOSTER, CREDITS AND COLLECTIONS 697-704 (8th ed. 1969).

66. See 11 U.S.C. §§ 506, 507,726 (Supp. 111979). Under the old Bankruptcy Act, an unsecuredcreditor had the same relative position in Chapter X corporate reorganization proceedings as a resultof the absolute priority doctrine. See 6, Pt. 2 W. COLLIER, BANKRUPTCY 9.10 (14th ed. 1969). Fur-ther, in the event of an arrangement under Chapter XI of the old Act, the rights of unsecured creditorshad to be modified or altered, while the status of other classes of security holders, including share-holders, could not be affected. See 9 W. Collier, supra, 9.01. Relatively few businesses that uti-lized Chapter XI survived. See D. STANLEY & M. GmTH, BANKRUPrCY: PROBLEM, PROCESS, REFORM 115(1971). Chapter 11 of the new Act is said to balance more equitably than former Chapters X and XIthe competing rights of debtors, unsecured creditors, secured creditors, and public holders ofsecurities. King, Chapter 11 of the 1978 Bankruptcy Code, 53 AM. BANKR UPrcY L.J. 107 (1979). Butsince the test for determining whether a plan is fair and equitable, at least when unsecured creditorsare the dissenting class, is a relaxed version of the traditional absolute priority rule, see Klee, All YouEver Wanted to Know About Cram Down Under the New Bankruptcy Code, 53 AM. BANKRUPTCY L.J.133, 143 (1979), query whether unsecured creditors will ultimately fare any better under the newAct.

Creditors may also attempt to determine their rights through a state court receivership. This ap-proach does not appear to have been used frequently. See D. STANLEY & M. GmTH, supra, at 120. Afinal possibility is that the corporation may simply close its doors. See id. at 108. In such event, itseems unlikely that assets in excess of the claims of secured creditors will exist.

67. For example, payments to unsecured creditors in asset cases concluded in United States Dis-trict Courts under the Bankruptcy Act during the period from July 1, 1976 through June 30, 1977,amounted to 4.5 percent of the unsecured claims allowed in such cases. ADMINISTRATIVE OFFICE OF THEUNITED STATES COURTS, TABLES OF BANKRuurcy STATISTICS A-16 (1978). These data included personaland business bankruptcies, and the business bankruptcies included business forms other than corpora-tions. Two scholars report that in a sample of business bankruptcies (again including all forms ofbusiness) unsecured creditors received only eight percent of the amounts proved and allowed. D.STANLEY & M. GmT, supra note 66, at 130.

68. The administrative expenses in asset cases concluded in United States District Courts underthe Bankruptcy Act during the period from July 1, 1976 through June 30, 1977 amounted to 22.9% ofthe amount realized in such proceedings. ADMINISTRATIVE OFFICEOFTHE UNITED STATES COURTS, supranote 67, at A-18. The dollar amount of such expenses was slightly less than the amount paid tounsecured creditors in such cases.

A sampling of business bankruptcies indicates the average (mean) time from the filing of thepetition until closing was more than 23 months. D. STANLEY & M. GITH, supra note 66, at 131-32.In 10% of the cases involving assets, the period was more than 48 months. Id. at 143.


poration's ability to pay its current obligations as they become due. 69

Such creditors as a class also have a long-term interest in the corpora-tion's continued existence as a viable, growing enterprise since that pros-pect portends a continuing source of business for the suppliers of that cor-poration. Both interests suggest a definite preference by trade creditorstoward retention of earnings.

4. Corporate officers

Although corporate law formally vests the power to formulate thedistribution policy for a corporation in its board of directors, 70 a numberof recent studies indicate that the critical policymaking functions in mostcorporations are likely to be performed by the corporation's officersrather than its directors. 7' That fact becomes significant in this contextbecause of the possibility that management may pursue its own goals in

69. Most commentators discussing the analysis of credit risk advise creditors to determine the ex-pected value of bad debt losses as a critical step in the credit-granting process. See, e.g., J. MAO.

supra note 59, at 265; W. SCHULTZ & H. REINHARDT, CREDIT AND COLLECTION MANAGEMENT 203 (3d ed.1962). Somewhere in that process most recommend an analysis of the debtor's ability to meet matur-ing obligations with particular emphasis upon expected cash-flows under varying business condi-tions. See J. MAO, supra note 59, at 259. For a detailed explanation of the process from thestandpoint of the debtor, see G. DONALDSON, CORPORATE DEBT CAPACITY 156-222 (1961).

A number of recent studies have used linear discriminant and other models to predict with consid-erable accuracy companies that will eventually become bankrupt. See, e.g.. E. ALTMAN, CORPORATEBANKRUPTCY IN AMERICA 57-82 (1971); J. MAO, supra note 59, at 260-63; Blum, Failing CompanyDiscriminant Analysis, 12 J. ACCOUNTING RESEARCH I (Spring 1974). A number of the vanables insuch models are surrogates for determinations of ability to pay debts as they mature.

See also Heath & Rosenfield, Solvency: The Forgotten Half of Financial Reporting. J. ACCOUNT.ANCY 48 (Jan. 1979) (arguing that accountants have not paid sufficient attention to providing informa-tion useful in evaluating solvency); L. HEATH, FINANCIAL REPORTING AND THE EVALUATION OF SOLVENCY31-85, 109-36 (Accounting Research Monograph No. 3, 1978) (presenting new statements and for-mats which will facilitate such analysis).

70. See, e.g.. I MODEL Bus. CORP. ACT ANN. §§ 6, 35, 45 (1971 & Supp. 1977).71. See, e.g., M. EISENBERG, THE STRUCTURE OF THE CORPORATION-A LEGAL ANALYSIS 139-41

(1976) (discussion of studies); M. MACE, DIRECTORS: MYTH AND REALITY 178-80, 184-86 (1971); Ba-con & Brown, Corporate Directorship Practices: Role, Selection and Legal Status of the Board, inCONFERENCE BOARD REPORT No. 646, at 16-17 (1975). As Eisenberg points out, closely held corpora-tions are typically managed by shareholder-managers. M. EISENBERG, supra, at 139.

Mace notes that on some financial problems (dividend policy was not specifically mentioned) out-side chief executive officers on the board may provide helpful information to the corporation's chiefexecutive officer. M. MACE, supra, at 179-80.

It remains to be seen whether the current efforts by the SEC to encourage independent boards ofdirectors, see, e.g., SEC. REG. & L. REP. (BNA) No. 437 (Jan. 25, 1978) (report of speech byChairman Harold H. Williams), will result in fundamental changes in the actual decisionmaking pro-cesses used by most corporations. See also Subcommittee on Functions and Responsibilities of Direc-tors, Committee on Corporate Laws, American Bar Association, Corporate Director's Guidebook,32 Bus. LAW. 5, 33 (1976) (recommending nonmanagement directors constitute a majority of theboard of directors). Eisenberg argues that about the best one could hope for, even with boards with a

376


formulating a distribution policy for the corporation, 72 and that such goalsmay not be consistent with maximizing the value of the enterprise. 73

Thus, some authors argue that managers may prefer to retain earnings forrelatively unprofitable projects rather than pay them out as distributionsbecause the reinvested funds may lead to advancement of existing manag-ers, hiring of new managers, increased budgets for the growing divisionsof the corporation, and other managerial emoluments. 74 Another schoolof thought argues that managerial control does not result in behavior con-trary to shareholder interests for at least three reasons: 75 first, managers

majority of independent directors, is that the directors will provide advice and counsel to the office ofchief executive, authorize major corporate actions, provide a modality by which persons other thanexecutives can be formally represented in corporate decisionmaking, and monitor the performance ofthe corporation's chief executive. M. EISENBERG, supra, at 141-85.

72. Rather than seek to maximize the value of the enterprise, management may seek to maxi-mize: (a) revenue subject to a profit constraint, W. BAUMOL, BUSINESS BEHAVIOR, VALUE AND GROWTH45-51 (rev. ed. 1967); (b) the rate of growth of sales, id. at 86-104; J. GALBRAITH, THE NEW INDUS-TRIAL STATE 166-78 (1967) (subject to an acceptable level of dividends and retained earnings); (c)managerial utility, i.e., staff expenditure, managerial emoluments, and discretionary profits, 0.Wn.uAMSON, THE ECONOMICS OF DISCRETIONARY BEHAVIOR: MANAGERIAL OBJECTIVES IN A THEORY OF THE

FIRM 28-37 (1964); (d) the lifetime incomes of the managers, Monsen & Downs, A Theory of LargeManagerial Finns, 73 J. POLITICAL ECONOMY 221 (1965); and (e) the growth of the enterprise, R.MARRIs, THE ECONOMIC THEORY OF "MANAGERIAL" CAPrTALISM 107 (1964); E. PENROSE, THE THEORY OFTHE GROWTH OFTHE FIRM 26-30 (1959).

73. A. BERLE & G. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY 114-16 (rev. ed.1968) (seminal statement of this position).

Herendeen argues that the models presented above, see note 72 supra, are basically similar andthat most can be construed to be consistent with his (and Penrose's) thesis that management desiresthat the enterprise maximize residual profits (i.e., profits less a relatively fixed rate of dividends). J.HERENDEEN, supra note 48, at 44-45. See also Grabowski & Mueller, supra note 47, at 20 ("Divi-dends are paid essentially to obtain security from takeover and similar external pressures."). Oneshould contrast this view of dividends as a quasi-contractual claim with the view of most financialtheorists that dividends should be determined after investment needs are met. See, e.g., L. SCHALL &C. HALEY, supra note 46, at 384-87. In addition, other authors argue that firms which appear to bemaximizing growth may actually be maximizing value because they are able to influence their dis-count rate through management of risk. Schramm & Sherman, Profit Risk Management and the The-ory of the Firm, 40 SOUTHERN ECON. J. 353,362 (1974).

74. See, e.g., Herendeen, Alternative Models of the Corporate Enterprise: Growth Max-imization and Value Maximization, 14 Q. REv. ECON. & Bus. 59 (Winter 1974) (and sources citedtherein). See also Rappaport, Executive Incentives vs. Corporate Growth, 56 H~Av. Bus. REV. 81(July-Aug. 1978) (arguing that most executive incentive systems focus on short-term results and thusoften cause lower long-term productivity).

75. In addition to the arguments following in text, this school of thought also raises the followingarguments: (a) specialization in ownership may develop whereby a small group of shareholders mayactively monitor management's performance; (b) competing potential managers will revealinformation to shareholders about management's failure to maximize profits; and (c) competition inthe product market makes assessment of management's performarice relatively easy. See, e.g.,Frech, Are Managers an Elite Clique with Dictatorial Power?, in THE ATTACK ON CORu'ORATE AMERICA

77, 78-79 (M. Johnson ed. 1978). The first point appears to be part of the market for control issue.See note 85 and accompanying text infra. The second point appears contrary to the analysis of twoscholars. Monsen & Downs, supra note 72, at 234-35. The third point has been questioned. Kaysen,Another View of Corporate Capitalism, 79 Q.J. ECONOMICS 41,42-44 (1965).


will be forced to use the equity capital market for additional funds neces-sary for expansion, and competition in that market will ensure value-maximizing behavior by the corporation; 76 second, stock options, 77

shares of the corporation owned directly, 78 and insider trading 79 will givemanagers an incentive to serve shareholder interests; and third, manage-ment's fear of takeovers will promote value maximization. 80 Each ofthese arguments has been rebutted by proponents of the first school ofthought. They argue that: (1) a very substantial number of corporationsmanage to avoid the disciplining influences of the securities or moneymarkets; 81 (2) stock options, 82 shares, 83 and insider trading 84 do not pro-vide the necessary incentive because the required causal connection be-tween an executive's performance and the profitability of the corporation

76. O. WILLIAMSON, supra note 72, at 21-22 (discussion of this argument). Lintner found a stable

pattern in the relative use by corporations of internally generated funds and externally generated

funds over the 50 years studied. Lintner, The Financing of Corporations, in THE CORPORATION IN MOD.

ERN SOCIETY 166, 182 (E. Mason ed. 1959). That finding is contrary to what one would anticipate ifmanagement had great discretion in sources of funds and thus tends to support the statement in the

text.77. See W. BAUMOL, THE STOCK MARKET AND ECONOMIC EFFICIENCY 81 (1965). The second and

third arguments are indirect means by which the capital market may induce efficiency. Baumol men-tions two other indirect capital market controls: (I) management may be concerned that the price of

its securities is stable; and (2) lenders may attach importance to the behavior of the corporation's

stock. But see Williamson, Corporate Control and the Theory of the Firm, in ECoNOsIC POLICY AND

THE REGULATION OF CORPORATE SECURITIES 281, 299 n. 35. (H. Manne ed. 1969) (finding these twocontrols to be "of second order importance.").

78. See W. LEWELLEN, THE OWNERSHIP INCOMEOF MANAGEMENT I I (1971) (finding that annual div-idends and capital gains from stock owned by senior executives in the corporations by which theywere employed exceeded the compensation received by such persons for services from the

corporations involved).79. See H. MANNE, INSIDER TRADING AND THE STOCK MARKET 138-41 (1966). In addition, one

study found that a corporation's dollar profit and rate of profit were the major variables explaining thelevel of executive compensation. R. LARNER, MANAGEMENT CONTROL AND THE LARGE CORPORATION 61(1970). See also Lewellen & Huntsman, Managerial Pal, and Corporate Performance, 60 A\I. ECON.

REV. 710 (1970) (both reported profits and equity market values were substantially more important in

determining executive compensation than were sales).

80. See Manne, Mergers and the Market for Corporate Control, 73 J. POLITICAL ECONOMIY 110.113 (1965); Peterson, Corporate Control and Capitalism, 79 Q.J. ECON. I, 21 (1965).

81. See W. BAUMOL, supra note 77, at 66-76 (empirical evidence and theoretical analysis sup-

porting this contention).82. See Williamson, supra note 77, at 299-301. Even Baumol concedes that the coincidence of

interest between management holding stock options and stockholders is likely to be incomplete with

respect to dividend policy. See W. BAUMOL, supra note 77, at 89.83. Williamson does not discuss shares owned by managers, see Williamson, supra note 77, but

the argument in text, see text accompanying notes 82-84, which he applies to options and insider

trading, appears equally applicable to management's ownership income.84. See Williamson, supra note 77, at 301-306. Williamson details other objections to insider

trading as entrepreneurial compensation: the difficulty in separating out windfall recipients of theinformation, the possibility of profiting from the use of adverse information, and the difficulty inmonitoring a particular executive's compensation level. For Manne's answers on these points, and

other objections to information as compensation, see H. MANNE, supra note 79, at 147-58.


cannot be established in most corporations; and (3) the market for corpo-rate control appears to be highly imperfect and thus management mayexercise substantial discretion before a takeover is attempted. 85 Unfortu-nately, the empirical studies on the question thus far have not produced adefinitive answer. 86

85. See Williamson, supra note 77, at 317. As Williamson states:It [control by displacement] is also subject to significant limitations. First, the market for cor-porate control would appear to be imperfect-either by reasons of barriers to entry into thismarket or high inference expense. Second, given existing institutions, it experiences hightransaction costs of achieving displacement. Thus the firm must cross a non-trivial thresholdbefore the threat of displacement will even be activated. Third, even if institutional arrange-ments were altered so as to reduce the transaction costs, the transition costs which adisplacement experiences inhibit a change. The discreteness characteristics of the solutionthus also stand as a bar to its employment. Finally, even if a displacement occurs, the newmanagement may eventually become subject to the organizational aspirations of its predeces-sors, so that the correction achieved does not persist.

The only empirical study on the question concluded that a market for control exists but that it is atleast partially ineffective in the sense that managements may be able to operate firms with a ratherlarge discrepancy between potential and actual value before an attempt to purchase control outrightbecomes probable. Hindley, Separation of Ownership and Control in the Modern Corporation, 13 J.L. &EcoN. 185, 209 (1970).

86. At last five studies have produced results that are consistent with the view that managers arepursuing policy goals other than maximizing the value of the shares issued by the corporation. Themost recent of these presented evidence that management-controlled firms with a high degree of mo-nopoly power report significantly lower profit rates than owner-controlled firms. Palmer, The Profit-Performance Effects of the Separation of Ownership From Control in Large U.S. Industrial Corpora-tions, 4 BELL J. ECON. & MANAGEMENT SciENcE 293 (1973). A second study found that the behavior oftwo variables in the managerial model posited by the authors could not be reconciled with astockholder welfare approach and concluded that the managerial model was both conceptually andstatistically superior to the pure stockholder maximization model. Grabowski & Mueller, Managerialand Stockhdolder Welfare Models of Firm Expenditures, 54 Rev. EcoN. & STATISTIcs 9, 21-22 (1972).A third study found a significantly lower return on internally generated funds in comparison to thatfor external funds, a result that is consistent with management's use of discretionary power over cashflow to pursue growth beyond a point beneficial to shareholders. Baumol, Heim, Malkiel, & Quandt,Earnings Retention, New Capital and the Growth of the Firm, 52 REv. EcoN. & STATISnCS 345(1970). A fourth study found that management-controlled firms in a sample of large corporations didearn a rate of return on equity that was lower than the return earned by owner-controlled firms butconcluded that the difference (0.5%) was modest enough to suggest that managerial discretion wasquite narrow. R. LARNER, supra note 79, at 63. Finally, the fifth study concluded that an owner-controlled group of firms outperformed management controlled firms by a considerable margin.Monsen, Chin & Cooley, The Effect of Separation of Ownership and Control on the Performances ofthe Large Firm, 82 Q.J. EcoN. 435, 442 (1968).

At least four studies have produced results that are consistent with the view that managers seek tomaximize the value of the firm. The most recent of these found no significant differences in firmperformance between groups of owner-controlled and management-controlled corporations. Soren-sen, The Separation of Ownership and Control and Firm Performance: An Empirical Analysis, 41SourmmtN EcoN. J. 145, 147 (July 1974) (Sorenson did find that generally the rates of return forowner-controlled firms were higher than those for management-controlled firms, but the differencewas not statistically significant.). A second study, based on a sample of the 200 largest firms over the1959-64 period, concluded that management-controlled firms had a higher dividend payout ratiothan that of owner-controlled firms (the same results were obtained for utility and industrial sub-groups). Kamerschen & Pascucci, Dividend Policy and Control Status, 85 PUB. UnIL. FORT. 43 (May

379


A second substantial issue is whether the process used by corporate de-cisionmakers in arriving at a distribution policy for the corporation in anyway resembles the balancing of interests contemplated by financial theor-ists and by legal policymakers. At least two surveys of company practiceshave produced lists of factors considered by policymakers that ifevaluated carefully by each company's decisionmakers would appear toconstitute a rational approach to the problem. 87 But another careful studyof decisionmaking practices concluded that the strongest factor in deter-mining the amount to distribute was precedent--' 'the dividend was rightbecause that was what had been paid in the past and there had been nosignificant protests from stockholders.' '88 The same study concluded thatthe companies involved were more concerned with maintaining financialmobility in the long run than with either a goal of dividend stability or agoal of maximum market value. 89

5. Corporate employees

The interest of a corporation's employees in its dividend policy has not

21, 1970). Finally, Kamerschen found that the type of control factor did not "explain" very much ofthe variation in profit rates among the 200 largest nonfinancial corporations included in the sample.(Kamerschen also found, but did not test, a positive and significant association between profit ratesand a change from nonmanagement to management control.). Kamerschen, The Influence of Owner-ship and Control on Profit Rates, 58 AM. ECON. REv. 432 (1968). See also McFetridge, The Effi-ciency Implications of Earnings Retentions, 60 REv. EcON. & STATISTICS 218 (1978) (concluding froman analysis of 205 Canadian corporations' performance that managerial earnings retention policieswere not a source of inefficiency).

87. A study by the Conference Board reports five dominant considerations in the minds ofdividend decision makers:

* The company's earnings record and its future prospects* The company's record of continuity or regularity of dividend payments and the desirabilityof maintaining such a record* Maintaining a stable rate of dividends per share of stock* The company's cash flow, present cash position, and its anticipated needs for funds* The needs and expectations of the owners of the common stock.

Harkins & Walsh, Dividend Policies and Practices, in CONFERENCE BOARD REPORT No. 522, at 3(1971). One hundred sixty-six firms were surveyed. Ninety-four firms mentioned earnings recordsand 13 firms mentioned shareholder's expectations. Id. at 4.

Another Conference Board study found that in smaller companies dividend policy was the result ofa compromise between the need for funds to finance further growth and the need for a satisfactoryreturn for shareholders. L. Laporte, Dividend Policy in the Smaller Company, in CONFERENCE BOARD,

MANAGINGTHE MODERATE-SIZED COMPANY, REPORT No. 9, at 9-10 (1969).It is interesting to note that in the Harkins and Walsh study not a single respondent stated that

changes in dividend policy were influenced by the company's bargaining posture with employees.See Harkins & Walsh, supra, at 4. Studies elsewhere indicate such factors are taken into account. SeeJ. FURLONG, LABOR IN THE BOARDROOM 38-39 (1977).

88. G. DONALDSON, STRATEGY FOR FINANCIAL MOBILITY 248 (1969)89. See id. at 248-49.

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received extensive study. 90 There seems little doubt, however, that em-ployees have a strong interest in the continued profitable operation of thecorporate employer. 9' Generally, that interest translates into a desire for ahigh rate of retention of earnings where the employees feel that such re-tentions will operate to make old jobs more secure and to create newjobs.92 Such desire presumably would diminish if the earnings were to bereinvested in laborsaving equipment. 93 And the desire may shift to a pol-icy aimed at maximizing the value of the enterprise if the employees havea substantial interest in a benefit plan that invests in the employer'sshares .94

C. Interests in Corporate Share Repurchase Policy

1. Publicly held corporations95

Financial theory offers no general prescription as to when shares

90. Very little empirical work has been done on the subject in the United States, probably be-cause the subject is not generally a permissible subject for bargaining. See R. GORMAN, BASIC TExT ONLABOR LAw, UNIONIZAnON AND COLLECTIVE BARGAINING 523 (1976). The best American work on em-

ployee interest in survival of the enterprise does not deal directly with the issue. See J. RIEGAL, EM-PLOYEE INTERESTIN COMPANY SUCCESS (1956). However, an excellent study by the German governmentof the operation of codetermination discusses the issue and offers considerable insight into probableattitudes of American workers on the issue. See Bonanno, Employee Codetermination: Origins inGermany, Present Practice in Europe, and Applicability To the United States, 14 HARV. J. LEGIs. 947(1977) (discussion of the Biedenkopf Report).

91. See J. FURLONG, supra note 87, at 37-38 (discussing findings of the Biedenkopf Report); J.RIEGEL, supra note 90, at 4-8; Steuer, Employee Representation on the Board: Industrial Democracyor Interlocking Directorate?, 16 COLUM. J. TRANSNAT'L L. 255,293 (1977). See also W. CARY, CASESAND MATERIALS ON CORPORATIONS 1485-86 (4th ed. 1969).

92. See J. FURLONG, supra note 87, at 38-39. Furlong notes, however, that this basic workermotivation is tempered by the recognition that the company's dividends must match general marketlevels if the company is to be able to secure necessary additional financing for its investments.

93. Id. at41-42.94. See id. at 39; Steuer, supra note 91, at 293.95. This section assumes that any corporation repurchasing shares will not violate rules 10b-6 or

lOb-13, 17 C.F.R. §§ 240. lOb-6, 240.10b-13 (1979), promulgated by the SEC under § 10(b) of theSecurities Exchange Act of 1934, 15 U.S.C. § 78j(b) (1977). The rules operate to preventrepurchases of shares when the corporation is either making a distribution of, or making a tender offerfor, the shares being repurchased. For a full discussion of the rules, see Lewis, The ManipulationProhibitions: Rules lOb-4, 10b-13, and lOb-6, 9 INsT. SEC. REG. 184 (1978). Section 10(b) is appli-cable to any transaction using any means or instrumentality of interstate commerce or of the mails, orany facility of any national securities exchange.

The section also assumes that any corporation repurchasing shares will not violate the spirit of therules promulgated (rules 13e-3, 13e-4) or proposed (rule 13e-2) by the SEC under § 13(e) of theSecurities Exchange Act of 1934, 15 U.S.C. § 78m(e) (1977). Rule 13e-3 requires issuers to discloseextensive information about the fairness and terms of any transaction the effect of which is to "goprivate". See 44 Fed. Reg. 46,736 (1979) (to be codified at 17 C.F.R. § 240.13e-3). Rule 13e-4specifies procedures that any corporation making a tender offer for its own shares must meet in order

Washington Law Review Vol. 55:359. 1980

should be repurchased 96 by a publicly held corporation. 97 Surveys of cor-porations that have repurchased significant quantities of shares in recentyears98 indicate that the management of such corporations had one ormore of the following objectives in pursuing such a policy: (1) obtainingshares for acquisition programs, conversions of other securities, or incen-tive compensation programs; (2) liquidating a portion of the corporation'sbusiness; (3) investing in the corporation's shares at what were perceivedto be bargain prices; (4) improving earnings per share by reducing thenumber of shares outstanding; (5) increasing the corporation's ratio ofdebt to equity; (6) reducing the cost of servicing small shareholders; (7)supporting the market price of the stock; and (8) distributing excessfunds, with the hope of providing a tax advantage to recipient sharehold-ers. 99 The shareholders who sell to the corporation in any of these types

to have a valid tender offer. 44 Fed. Reg. 49,406 (1979) (to be codified at 17 C.F.R. § 240.13e-4).Proposed rule 13e-2 specifies price and volume restrictions that must be met when issuers repurchasetheir own shares in open market and in private transactions. 38 Fed. Reg. 34,343 (19731. Rulesadopted under 13e are applicable to any corporation that has a class of equity securities registeredunder § 12 of the Securities Exchange Act. See 15 U.S.C. § 78m(e) (1977). Every corporation whichis engaged in interstate commerce, or in a business affecting interstate commerce, or whose securitiesare traded by use of the mails or any means or instrumentality of interstate commerce, and which hastotal assets exceeding $ 1,000,000 must register any class of equity security held of record by 500 ormore persons. 15 U.S.C. § 78d (g) (1) (1977) (§ 12 (g) (1) of the Securites Exchange Act of 1934).

96. The term "repurchases" is used in this section to include reacquisitions by a corporation ofits own shares by means of block purchases from individuals, open market purchases, and tenderoffer to all or a class of the corporation's shareholders.

It is assumed for purposes of this section that any corporate repurchase will not be undertaken insuch manner as to prefer either insiders to shareholders generally or shareholders to creditors.

97. For a preliminary attempt at such a prescription, see Woods & Bingham, Stockholder Distri-bution Decisions: Share Repurchases or Dividends?, I J. FINANCIAL & QUANTITATIVE ANALYSIS 15

(1966).It should be noted that several articles reject a number of common explanations for the growth in

repurchasing of shares and posit that such growth is primarily related to the tax advantage repurchasesoffer to most selling shareholders as compared to dividend distributions. E.g., Bierman & West, TheAcquisition of Common Stock By the Corporate Issuer, 21 J. FINANCE 687 (1966). Detailed models ofrepurchases for that purpose are available. See, e.g., Elton & Gruber, The Effect of Share Repur-chases on the Value of the Firm, 23 J. FINANCE 135 (1968).

98. For the most comprehensive surveys, see Guthart, Why Companies Are Buying Back TheirOwn Stock, 23 FINANCIAL ANALYSTS J. 105, 106-10 (1967); F. Walsh, Repurchasing Common Stock,

in CONFERENCE BOARD REPORT No. 659, at 5-14 (1975). Both surveys focused on corporations listedon the New York Stock Exchange that had repurchased a substantial number of shares during theperiod covered by the respective surveys (1973 in Walsh; 1956-65 in Guthart).

99. The list in text presents the objectives in order of approximate frequency that the objectivewas identified by respondents in both studies. See Guthart, supra note 98, at 106-110; Walsh, supranote 98, at 5-14. Walsh lists several additional objectives identified by a small number of respon-dents. Id. Most of these objectives, however, are simply specific examples of the purposes stated intext.

Another series of studies compared various financial, operating, and security-market parameters ofcorporations actively engaged in repurchasing with such parameters for nonrepurchasingcorporations. See, e.g., Rosenberg & Young, Firms Repurchasing Stock: Financial Security Markets

382


of repurchases require extensive disclosure in order to make an informedjudgment on the sale. 100 The concerns of other groups interested in a cor-porate decision to repurchase vary depending upon which of these reasonsis the dominant purpose for the acquisition.

and Operating Characteristics, 30 U. MICH. Bus. Rav. 17 (May 1978) (concluding that repurchasingfirms had a greater ability to carry debt than a group of control firms, had operating performancegenerally inferior to that of control firms, and appeared to have less attractive investment opportuni-ties than control firms). See also Dyl, A Critical Examination of Share Repurchase: Dyl and Whitevs. Norgaard and Norgaard, 3 FINANCIAL MANAGErENT 49 (1974); Finnerty, Corporate Stock Issueand Repurchase, 4 FINANCIAL MANAGE ENT 62 (1975); Norgaard & Norgaard, A Critical Examinationof Share Repurchases, 3 FINANCIAL MANAGEMENT 44 (1974); Rosenberg & Young, Price Volatilityand Corporate Repurchasing, 17 NEa. J. EcoN. & Bus. 57 (1978).

A third type of study surveyed repurchasing companies to determine the purpose for which thereacquired shares were subsequently reissued. Austin, Treasury Stock Reacquisitions by American

Corporations: 1961-67, 37 FINANCIAL EXECUnVE 41 (1969). The vast majority of companies studiedreissued the shares for the first purpose noted in text.

100. A detailed discussion of a corporation's obligation to disclose information in connectionwith repurchase of shares is beyond the scope of this paper. In general, however, its obligation isdetermined by the rules promulgated by the SEC under §§ 10(b) and 13(e) of the Securities Exchange

Act of 1934, 15 U.S.C. §§ 78j(b), 78m(e) (1977). Its obligation to disclose and its other duties underrule 10b-5, 17 C.F.R. § 240. lOb-5 (1979), are still evolving. For a discussion of possible require-ments, see Malley, Corporate Repurchases of Stock and the SEC Rules: An Overview, 29 Bus. LAW.117, 119-21 (1973). See also Baker, Purchases by a Corporation of Its Own Shares for EmployeeBenefit Plans, 22 Bus. LAW. 439 (1967) (discussing the application of rule lob-5 to corporate repur-

chases when the corporation was simultaneously engaged in securities offerings).Three final rules have thus far been adopted under § 13(e), 15 U.S.C. § 78m(e) (1977): rule 13e-1,

13e-3, and rule 13e-4. Rule 13e-I applies to a corporation that has received notice of a tender offerfor its shares. During the period the tender offer continues, the corporation may not repurchase any ofits equity securities unless it has filed with the SEC and provided to its equity security holders infor-mation concerning the means to be used in accomplishing the repurchases, the purposes for therepurchases, and the source of the funds to be used in the repurchases. See 17 C.F.R. § 240.13e-I(1979). Rule 13e-3 requires issuers to disclose extensive information about the terms and fairness oftransactions causing any registered class of equity securities of the issuer to be held of record by lessthan 300 persons or causing any registered class of equity securities no longer to be listed by a na-tional securities exchange or quoted by a national securities association. Thus, issuers are required tostate their views of the fairness of proposed transactions and to support such views with a detailedstatement of material facts upon which they are based. The rule also provides that a list of materialfactors must be discussed in such statement, including whether the transaction is structured so thatapproval by a majority of unaffiliated shareholders is required and whether the consideration offeredconstitutes fair value. See 44 Fed. Reg. 46,736 (1979) (to be codified as 17 C.F.R. § 240.13e-3).Rule 13e-4 requires issuers making offers for their own shares to hold the offer open for a minimumperiod, afford shareholders the right to withdraw tendered securities within a specified time period,and, if the tendered securities exceed the number the issuer is obligated to accept, accept tendered

securities on a pro rata basis. It also requires that the issuer provide security holders of the class ofsecurities subject to the tender offer with a statement containing the terms and conditions of the tenderoffer, the source and amount of funds or other consideration that will be expended for the securities,the purpose of the tender offer, recent transactions in the class of subject security by the issuer, speci-fied contracts, arrangements, understandings or relationships regarding the tender offer, identifica-tion of persons retained to make solicitations concerning the tender offer, extensive financialinformation, and other material information necessary to make required statements not materiallymisleading. See 44 Fed. Reg. 49,406 (1979) (to be codified at 17 C.F.R. § 240.13e-4).

383


Absent the conditions for the third, 1 1 fourth, 102 or eighth 10 3 type ofrepurchase, it is hard to find a significant financial benefit for any of theinterested groups in a corporation's repurchase of shares for future uses(the first type of repurchase). Such a repurchase results in the corporationusing cash currently available to satisfy a future obligation that requiresthe issuance of corporate shares. Trade creditors and senior security hold-ers generally will prefer that the corporation use authorized but unissuedstock to satisfy its obligation rather than cash. 1

04 A secondaryconsequence of repurchases for future uses, however, is that the numberof shares ultimately outstanding is the same as the number outstandingbefore the repurchase was made, and persons who are shareholders in thecorporation throughout the full sequence of transactions will end up withthe same proportionate interest in the corporation that they had before therepurchases began. 105 This benefit for the nonselling shareholders cannot

101. Both surveys mentioned the possibility of bargain repurchases in connection with repur-chases for future uses. See F. WALSH, supra note 98, at 7; Guthart, supra note 98, at 108-09.

102. See R. HIGGINS, FINANCIAL MANAGEMENT-THEORY AND APPLICATIONS 247 (1977).Guthart discusses the first type of repurchase in terms of maintaining the corporation's current

equity level. Guthart, supra note 98, at 107. It is unclear whether this is a reference to the fourth typeof repurchase advantage (debt-equity ratio) or to the bargain repurchase point. It is clear that absent abargain repurchase, shareholders' equity will be the same in total irrespective of whether there is arepurchase for future use or a cash dividend followed by the issuance of authorized, unissued sharesfor the future use.

103. See Chirelstein, Optional Redemptions and Optional Dividends: Taxing the Repurchase ofCommon Shares, 78 YALE L.J. 739, 744-45 (1969). Chirelstein argues that management wouldrarely make such repurchases but for the tax advantage.

104. The preference for the use of authorized, unissued stock will not be altered even if the cor-poration must bear the cost of gaining shareholder approval to authorize new shares.

A number of writers argue that repurchases are particularly important in facilitating acquisitions bythe corporation where the seller will accept only stock. See, e.g., Guthart, supra note 98, at 108. Theseller's objective obviously could also be met by issuing authorized, unissued shares.

105. Professor Chirelstein offers several reasons why officers of the corporation may prefer re-purchases for future uses:

Thus, an increase in ordinary dividend payments, even in the form of a year-end extra, mightmake it necessary for the corporation to offer the shareholders some explanation if the in-creased payments was not coincident with a substantial rise in reported net earnings.Assuming that the dividend increase merely reflects the absence of attractive investment op-portunities, the explanation, if perfectly forthright, would tend to cast doubt on management'sability because it would suggest that the company had reached a condition of partial liquida-tion. On the other hand, to the extent that share repurchasing is carried out through ordinarybrokerage transactions in the market, the entire matter is less public and the shareholders mayneither expect nor seek a detailed explanation of the transaction. Morever, since companyexecutives who hold unexercised stock options do not share in ordinary pro rata dividend pay-ments, a dividend declaration which is desirable from the viewpoint of shareholders may bemuch less so from the viewpoint of optionees. By contrast, share repurchase confers the samequantitative benefit on option holders in the form of increased option values as it does on non-selling shareholders in the form of increased share values.

Chirelstein, supra note 103, at 745-46 (footnotes omitted). None of these reasons gives managementa legitimate interest in the policy decision to make repurchases. But see Shad, Stock Reacquisition

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otherwise be arranged without cost to them. 106 However, given the rela-tively low value accorded to maintenance of proportionate interests inpublicly held corporations, 10 7 and given reasonably significant disadvan-tages in repurchases for future uses for other interested groups, it wouldappear that justification of this common type of repurchase must be foundelsewhere.

Analysis of the use of share repurchases as a means of liquidating aportion of the corporation leads to a similar conclusion. Repurchases forsuch a purpose have typically been made by corporations that have accu-mulated substantial amounts of cash, either because of a contraction ofthe corporation's activities or because of a reduction in the need for cashwithin the corporation's current operations, and that do not foresee suffi-ciently profitable future expansion of their activities. 10 8 Absent theconditions for the third, fourth or eighth type of repurchases, it is againhard to find a significant financial benefit for any of the interested groupsin any such repurchase. 109 Even though trade creditors and senior securityholders may view investment of the excess funds in another enterprise asincreasing the risk connected with their interests, 110 both groups undoubt-edly would prefer such investment to the distribution of the funds by re-purchase of shares. If the repurchases are not pro rata, however, share-holders who chose not to sell will after the repurchase possess, withoutcost, an increased proportionate interest in the corporation. "'1 This factorappears to be significant only in the event that the effect of therepurchases is to transfer or solidify control of the corporation. 112 Repur-

Programs, in TREASURER'S HANDBOOK 1019-20 (F. Weston & M. Gondzwaard eds. 1976) (citing asan advantage of share repurchases that the percentage interest in the corporation's shares ofmanagement will increase).

106. Chirelstein argues that the same end can be achieved by distributing the available cash as adividend and by the shareholders reinvesting the dividends in the corporation's shares. Chirelstein,supra note 103, at 744. This argument appears to ignore the tax cost to the recipient shareholdercaused by the receipt of the dividend and the transaction cost for the shareholder of reinvesting thedividend in the corporation's shares.

107. See, e.g., Drzycimski, The Stock Repurchase Decision, 13 MARQ. Bus. REv. 159, 164(Winter 1969); see also the discussion of preemptive rights in publicly-held corporations in W. CARY,supra note 91, at 1144-46.

108. See Guthart, supra note 98, at 106.109. Id. at 106-07.110. Id. at 107.111. See Chirelstein, supra note 103, at 743. The only alternative means of accomplishing this

end, a pro rata redemption or dividend followed by reinvestment of the proceeds in shares by share-holders desiring a larger proportionate interest, entails tax and transaction costs.

112. Compare the suggestion by some commentators that some repurchases are made to thwart atakeover. See, e.g., L. ScHAL. & C. HALEY, INTRODUCTION TO FINANCIAL MANAGEMENT 625 (1977).

Absent some effect on control, shareholders' interests in such transactions appear to be identical tothose related to maintaining their proportionate interest.


chases undertaken for the purpose of affecting the control of the corpora-tion seem at best to be of questionable merit. 11 3 Thus it again appears thatjustification of this type of repurchase must be found elsewhere.

The third and fourth types of repurchases appear to have a similar im-pact upon the various interested groups. The third type is undertakenopportunities available to the corporation. 116 Trade creditors and seniorthe public,1 4 concludes that the market price of the corporation's sharesis less than the long-term value it perceives for such shares." 5 Manage-ments have been advised to undertake the fourth type of repurchase when-ever earnings per share will increase more as a result of the repurchasethan they would increase as a result of investment of the funds in otheropportunities available to the corporation. 16 Trade creditors and seniorsecurity holders presumably will prefer that the funds be retained rather

113. See Bennett v. Propp, 41 Del Ch. 14, 187 A.2d 405 (1962) (holding that repurchases topreserve control of a corporation were improper). Cf. recent S.E.C. rule 13e-3, 44 Fed. Reg. 46,741(1979) (to be codified in 17 C.F.R. § 240.13e-3) (regulating going private transactions by corpora-tion). Another commentator has reached the same conclusion without reference to the possibile ille-gality of such transactions. H. BIERMAN, DECISION MAKING AND PLANNING FOR THE CORPORATE TREASURER

137 (1977).114. This condition, imposed by recent writers on the subject, see Coates & Fredman, Price

Behavior Associated with Tender Offers to Repurchase Common Stock, 44 FINANCIAL EXECUTIvE 40,41-42 (Apr. 1976), is designed to alert management to the requirements of S.E.C. rule lOb-5, 17C.F.R. § 240.10b-5 (1979), prohibiting the use of material inside information in making suchrepurchases. For discussion of these rules, see sources cited in noted 100 supra.

115. The literature contains relatively little guidance as to how management should make thisdetermination apart from the suggestion that the condition may exist if the market price is substan-tially below book value per share, see Coates & Fredman, supra note 114, at 41, or if the shares sellat low price/earnings ratios. See Shad, supra note 105, at 1019. The significant expansion in thevolume of repurchases during periods of stock market decline, see text accompanying note 12 supra.may indicate, however, that managements are simply comparing current market prices with recenthigh prices in making the determination.

The possibility that management can detect undervaluation of the corporation's shares is contraryto the argument that securities markets are reasonably efficient. See Stewart, Should A CorporationRepurchase Its Own Stock?, 31 J. FINANCE 911, 912 (1976). Stewart suggests that the contradiction isovercome by the studies showing corporate insiders possess special abilities in detecting and exploit-ing price-value divergences. Id. at 911-12. This explanation, however, suggests that managementmust be careful to determine that information being evaluated is public in order to avoid the applica-tion of rule lOb-5.

116. See Ellis, Repurchase Stock to Revitalize Equity, 43 HARV. Bus. REv. 119, 123-26,(July-Aug. 1965). This process is labeled by some as an investment in the corporation's shares. See,e.g., Letter from C.R. Rundell to the editor, 43 HARV. Bus. REv. 39, 39-40 (Nov.-Dec. 1965). Thelabel has generally been rejected. See Drzycimski, supra note 107, at 163.

Guthart notes that there are two possible biases that management must avoid in applying this tech-nique. First, earnings per share may appear higher as a result of the repurchase simply because certainelements of the gain from alternative investments (e.g., market appreciation of stock owned in anotherenterprise) are not included in the corporation's earnings. Second, management may feel that the riskpresented by repurchasing shares is less than that presented by another investment solely because oftheir familiarity with the corporation's business. Guthart, Why Companies Are Buying Back TheirOwn Stock, 23 FINANCIAL ANALYSTS J. 105, 106-07 (Mar.-Apr. 1967).

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than expended for either type of repurchase. If management accuratelyperceives that the shares are undervalued or that the earnings per sharewill increase more by repurchases, shareholders who retain their shares inthe corporation should benefit through greater appreciation in the value oftheir shares than would have occurred had the repurchase not beenmade. 117 Although the empirical studies on the issue do not reach entirelyconsistent results, lib the most recent general study119 found that, after anumber of years of similar performance, 120 the stock market performanceof the shares of repurchasing companies' l2 eventually was significantlybetter than the performance of shares of nonrepurchasing companies. 122

117. Thus, an old Wall Street saw is said to proclaim, "when a corporation issues a tender offerfor its own shares, don't tender your shares if you are a stockholder and buy the security if you arenot." Rosenberg & Young, The Performance of Common Stocks Subsequent to Repurchase by Re-cent Tender Offers, 16 Q. REv. EcON. & Bus. 109, 109 (Spring 1976).

118. Compare the results set forth in text with results of the following studies. Coates and Fred-man concluded from a study of 85 cash tender offers during the period from June 1962 to June 1973that had an investor purchased a portfolio of these securities during the week of the tenderannouncement and held it for 51 weeks, the investor would have experienced a negative return of1.4% compared to having invested in stocks represented in the Standard & Poor's Index. Coates &Fredman, supra note 114, at 43-44. Rosenberg and Young concluded from a study of 96 tenderoffers during the period from November 1965 to January 1974 that index securities would have pro-vided better performance than the tendered security for periods up to two years after the announce-ment of the tender offer. Rosenberg & Young, supra note 117, at 109, 112-13. Young concludedfrom a study of 152 tender offers during the period from December 16, 1944, to October 8, 1965, thatthe price action of the common stocks for which tender offers had been issued for the year followingthe tender offer was "significantly less favorable than the general market for equity securities" dur-ing the same time. Young, The Performance of Common Stocks Subsequent to Repurchase, 23FINANCIAL ANALYSTS J. 117, 119 (Sep.-Oct. 1967). Ellis and Young extended Young's sample totender offers made up to 1970 with similar results. C. ELLIS & A. YOUNG, THE REPURCHASE OF COMMONSTOCK 152-53 (1971). Petty and Pinkerton studied the daily holding period returns, after the returnsof the overall market had been removed, of shares subject to tender offers from early 1974 throughmid-1976. Their findings suggest that price improvement in shares subject to a tender offer typicallystarts when information regarding the company's plan to repurchase first reaches investors. Petty &Pinkerton, The Stock-Repurchase Decision: A Market Perspective, 1 J. ACCOUNTING, AUDmNG & FI-NANCE 99, 114 (Winter 1978).

See also Rapp, Treasury Common Stock Financing As An Investment Process, 5 Miss. VALLEY J.Bus. ECON. I (Fall 1969). Rapp computed the rate of return realized by 30 corporations using treasuryshares to satisfy obligations requiring shares. The rate of return ranged from 4% to 40%. Id. at 8, 9.

119. Stewart, Should A Corporation Repurchase Its Own Stock?, 31 J. FINANCE 911 (1976).Stewart examined the price performance subsequent to all types of repurchases made by the corpora-tions on the Compustat Annual Industrial Tapes for the years 1955 to 1972.

120. The number of years varied from one to three depending on the percentage of shares repur-chased. Id. at 917-19. Stewart hypothesizes that this delayed market reaction is the result of an initialmarket response to the defensive nature of repurchase decisions which is not overcome until manage-ment has been tested for a number of years. Id. at 919-20.

121. Repurchasing companies are defined as companies purchasing more than .25% of theirshares during any of the years studied. Id. at 913.

122. Id. at 917-18.


The study also indicates that corporations repurchasing a moderateamount of shares (3.25-4.24%) enjoyed performance superior to that ofcorporations repurchasing either relatively small or relatively large num-bers of shares. 123 Thus, it appears that at least in some cases shareholdersretaining shares in the repurchasing corporations benefit from the thirdand fourth types of repurchases. 124

Corporations have been advised to undertake the fifth type of repur-chase whenever they find themselves with a less than optimal debt-equityratio and with either unused debt capacity or excess cash. 125 Such a cor-poration can immediately increase its ratio either by borrowing funds andusing the proceeds to repurchase shares or by using the excess cash torepurchase shares. It is clear, however, that the same financial effectscould be obtained for the corporation by borrowing the funds and distri-buting them as a dividend, by distributing the debt as a dividend, or bydistributing the excess cash as a dividend. 126 Thus, this type of repur-chase apparently is undertaken primarily for the tax advantage 27 it pro-vides to recipient shareholders and should be analyzed along with theeighth type of repurchase.

The sixth type of repurchase appears to provide benefits for each of theinterested groups in the corporation. This type of repurchase has been rec-ommended whenever the present value of the costs of servicing small

123. Id. at 917. Small amounts of shares are defined as .25% to 1.24% of a company's shares.Large amounts of shares are defined as in excess of 5.25% of a company's shares.

Stewart hypothesizes that companies purchasing small amounts of shares are usually seeking themfor future uses and that in such decisions significant undervaluation is not usually a factor. On theother hand, companies repurchasing large amounts of shares tend to be involved in a major reorgani-zation as a means of correcting basic financial problems of the corporation. Thus, their problems tendnot to be resolved as simply as situations in which the undervaluation stems from general marketfactors. Id. at 919-20.

124. Chirelstein argues that perhaps management ought to be indifferent to whether the antici-pated price rise is shared by a larger or a smaller group of shareholders. Chirelstein, supra note 103,at 745.

125. See, e.g., Brigham, The Profitability of a Firm's Purchase of Its Own Common Stock, 7CAL. MANAGEMENT REv. 69, 73 (Winter 1964); Ellis, supra note 116, at 126-27.

126. See H. BIERMAN, supra note 113, at 138; Drzycimski, supra note 107, at 162. Both writerspoint out that the possible effect of the repurchase on earnings per share can be duplicated by combin-ing a reverse stock split with the cash dividend.

Coombes and Tress argue that share reacquisitions have an advantage over dividends becauserepurchases are available for use at any time. Coombes & Tress, The Financial Implications of Cor-porate Share Reacquisitions, 13 ABAcus 40, 45 (June 1977). It is doubtful that repurchases have anymajor advantage on this score in view of expanding disclosure requirements being imposed on repur-chasing corporations, see discussion in note 100 supra, and in view of the relatively short time thatit takes to determine shareholders of record for dividend payment.

127. See Chirelstein, supra note 103, at 742-47.

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Vol. 55:359, 1980


shareholders 128 over the period of time they are shareholders' 29 exceedsthe benefits the corporation will receive130 or reductions in cost it willachieve' 3 ' if the small holders remain as shareholders. Assuming that thecorporation's solvency is not threatened by the repurchases, the corpora-tion's trade creditors have no more reason to complain about this type ofrepurchase than they have to complain about any long-term investment bythe corporation. Holders of the corporation's senior securities or of thecorporation's remaining common shares both should benefit from thelong-term enhancement of the corporation's common equity. Even theselling shareholders may benefit from the transaction through receipt of apossible premium over the market price of the shares and elimination ofbrokerage fees of the sale. 132

Repurchases for the purpose of supporting the market price 133 of theshares concerned have been made by corporations in two quite different

128. Young and Marshall present a number of estimates of the various costs in servicing eachindividual shareholder. Young & Marshall, Controlling Shareholder Servicing Costs, 49 HARv. Bus.Rev. 71, 73-74 (Jan.-Feb. 1971). Their most recent data is a survey (undated but apparently reason-ably close to the publication date) showing the following:

Cost Per Holder Companies EstimatingLess than $1.00 3$I.00 to $1.99 20$2.00 to $4.99 31$5.00 to $9.99 9$10.00 or more 13

Total 76

129. Young and Marshall are not clear as how these data are to be derived.130. Young and Marshall recognize that the corporation receives a number of benefits from

having large numbers of shareholders that cannot be quantified. Among those benefits mentionedwere the possibility the shareholders will be customers or salespersons for the company's products,the possibility the shareholders as a group may exert political influence on the corporation's behalf,and the possibility that a smaller group of shareholders makes it easier for a corporate raider to mounta campaign. Young & Marshall, supra note 128, at 74-75.

One writer notes the conflict between this type of repurchase and the notion of "people's capital-ism," i.e., broad participation in the ownership of the corporation's shares. See Guthart, supra note98, at 109. This conflict may explain why relatively few companies undertake this type of repur-chase. See Walsh, supra note 98, at 8; Young & Marshall, supra note 128, at 72.

131. Young and Marshall focus on the fixed cost of preparing the repurchase campaign, the unitcost of solicitation, and the transaction cost for each shareholding repurchased. Young & Marshall,supra note 128, at 77. It is unclear whether the last cost includes the cost of the shares repurchased, aspresumably it should. See also Marshall & Young, A Mathematical Model for Re-Acquisition ofSmall Shareholdings, 3 J. FINANCIAL & QuANTrrATIVE ANALYSIS 463 (1968). Perhaps their model doesnot include such cost since it also omits as a cost of having the shares outstanding the dividends thatwould have to be paid on the shares in the future. Even if one assumes that such dividends discountedto present value equal the market price of the shares, it still appears that the model should include as acost any premium over the current market price.

132. See Young & Marshall, supra note 128, at 74.133. It is assumed that corporations attempting to support the market price are not in violation of

sections 9(a)(2) and 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78i(a)(2), 78j(b)(1976). Section 9(a)(2) makes it unlawful to effect a series of transactions in any security registeredon a national securities exchange creating actual or apparent active trading in such security or raisingor depressing the price of such security where the purpose of such actions is to induce the purchase or

389


situations: first, a number of companies have repurchased shares in a gen-

erally declining market with the hope of stabilizing the price for the

shares repurchased; 134 and second, other companies have repurchased

large blocks of shares that would otherwise inhibit trading in the shares

because of the possibility that public sale of the blocks might cause a de-cline in price. 135 Regardless of the situation, however, trade creditors and

senior security holders will prefer that the corporation retain the funds

rather than expend them on the repurchases. But selling shareholders, and

possibly shareholders remaining after the repurchase, 136 will gain from

such transactions if the repurchases succeed in preventing or arresting a

decline in the price for the corporation's shares. The limited amount of

evidence available on the question suggests that such effects are not likelyto result. 137 It therefore appears that justification of such repurchasesmust be found elsewhere.

Repurchases made with the intent 13 8 of providing greater tax benefits to

shareholders than would result from a dividend of an equivalent amountgenerally 139 must, if that intent is to be realized, not be pro rata. 140 If the

sale of such security by others. Section 10(b) makes it unlawful for any person, by any means orinstrumentality of interstate commerce or of the mails, to use in connection with the purchase or saleof any security any manipulative or deceptive device or contrivance in contravention of such rules asthe S.E.C. may prescribe. Rule 10b-5, 17 C.F.R. § 240.10b-5 (1979), adopted under section 10(b).may apply to purchases for the purpose of putting a "floor" under a stock's open market price. SeeMalley, supra note 100, at 119.

134. See Walsh, supra note 98, at 7-8.135. See Guthart, supra note 98, at 109.136. Shareholders remaining after the repurchases will benefit from such transactions only in the

event that the repurchases increase the value of the remaining shares. See Drzycimski, supra note107, at 165. Such result may occur if management has made a bargain repurchase. See text accompa-nying notes 114-24 supra.

137. Walsh reports that companies making repurchases to support the market price of their shares

(apparently all in a period of a generally declining market) most frequently reported little or no suc-cess. Walsh, supra note 98, at 9-10. See also the studies reviewed in note 118 supra which indicatethat short-term success is most unlikely.

138. It is interesting to note that none of Walsh's respondents stated that the purpose of a repur-chase was to provide a tax benefit to the selling shareholders. See Walsh, supra note 98, at 6. Guthartmentions such a purpose for a repurchase. Guthart, supra note 98, at 107.

It would appear that corporations undertaking such repurchases must have a majority ofshareholders who prefer capital gains to dividends. See text accompanying notes 36-43 supra.

139. Distributions in redemption (repurchases) of the corporation's stock may also be eligible forcapital gains treatment if the distribution qualifies as a partial liquidation under section 346 of theInternal Revenue Code of 1954. The type of partial liquidation directly relevant to our subject is oneresulting from a contraction of the corporation's business. See generally B. BirrKER & J. EusrxcE,FEDERALINCOMETAXATIoN OF CORPORATIONS AND SHAREHOLDERS 9-59 to 9-72 (4th ed. 1979).

140. Section 302(b) of the Internal Revenue Code of 1954 provides for capital gains treatment ona redemption (repurchase) if the redemption results in a complete termination of the shareholder'sstock interest in the corporation, reduces the shareholder's percentage ownership of the corporation'svoting stock to less than 80% of such ownership before the repurchase, or is not essentially equivalentto a dividend. The latter test was interpreted by the Court in United States v. Davis, 397 U.S. 301,

390


funds involved could have been validly distributed as a dividend, tradecreditors and holders of senior securities should be indifferent to the formof the distribution. 141 All of the corporation's common shareholders ben-efit by being able to decide whether, and to what degree, to participate inthe cash distribution.142 Shareholders desiring a current financial returngain by being able to receive an amount equal to their basis tax free, withany additional proceeds eligible for capital gains taxation. 143 The share-holders who retain their shares may also gain by enhancement of thevalue of their shares due to the impact of the repurchase upon the corpora-tion's earnings per share. 144

2. Closely held corporations145

Shareholders of closely held corporations often attach great importanceto possible repurchase of their shares by the corporation. Because themarket for the shares of such corporations is usually quite limited, corpo-rate repurchase may represent the only means by which a shareholder de-siring to sell can realize upon his or her investment. 146 In addition, corpo-rate repurchase may avoid disruption of the often delicate balance ofoperating control of the corporation and thus benefit continuing share-

313 (1970), to require "a meaningful reduction in the shareholder's proportionate interest in the cor-

poration." Bittker and Eustice conclude that "pro rata redemptions, especially by closely held corpo-

rations, will seldom if ever qualify under § 302(b)(1)." B. BrrraKa & J. EusrTcE, supra note 139, at9-33.

141. This statement assumes that the effects of the two types of transactions will be the same

under the state statute. Such will not be the case where the jurisdiction has adopted sections 6 and 68

of the Model Business Corporation Act and the shares are canceled. In such circumstances, surplusequal to the par value of the shares canceled will be recycled. See D. HERwrrz, BUsINEsS PLANNING425-26 (1966). Since surplus will therefore be reduced by more in the event of a dividend than by a

repurchase, creditors and senior security holders will prefer a dividend.142. See Coombes & Tress, supra note 126, at 41.143. This assumes that the redemption qualifies under section 302(b) of the Internal Revenue

Code of 1954 and thus that amounts received are treated as payments received in exchange for thestock. See discussion in note 140 supra.

144. See J. MAO, CORPORATE FINANCIAL DEcIsIoNs 345 (1977); Coombes & Tress, supra note 126,

at 44. As to whether repurchases will in fact give rise to such enhancement, see authorities discussedin note 118 supra.

145. This section assumes that any repurchase will be made after adequate disclosure of all mate-rial information concerning the corporation and thus that neither common law disclosure duties nor

rule 1Ob-5 will apply. For discussion of the corporation's obligation to disclose in this context, see

W. PAINTER, CORPORATE AND TAX AsPECrs OF CLOSELY HELD CORPoRATIONS 240-48 (1971). This

section also assumes that director-shareholders authorizing any such repurchase will not violate a

fiduciary duty to other shareholders. See also Donahue v. Rodd Electrotype Co., 367 Mass, 578,328 N.E. 2d 505 (1975).

146. See, e.g., Kahn, Mandatory Buy-Out Agreements for Stock of Closely Held Corporations,68 MICH. L. RaV. 1, 3-8 (1969).


holders. 147 It is clear that trade creditors and senior security holders gen-erally will prefer that these advantages be obtained by means of cross-purchase agreements between the shareholders rather than by repurchasesby the corporation. The balance of a complex series of tax considerations,however, appears to favor repurchases by the corporation in such circum-stances. 148 And if the corporation gives creditors adequate notice of itsobligation and takes reasonable steps to fund its obligation in advance,much of the creditors' complaint should be muted.

D. Interests in Administration of Legal Limitations on CorporateFinancial Distributions

Virtually all of the states that regulate corporate distributions to share-holders also impose liability on assenting directors of any corporation thatmakes an illegal distribution. 1

49 Directors attempting to determine the va-lidity of a proposed distribution under a typical statutory system oftenconfront difficult issues of statutory construction, asset valuation, or ac-counting principle interpretation 150 in which their liability if they err issubstantial and in which their need for expert assistance is acknowl-

147. Id. at 8-9.148. Prior to the Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520, and the adoption

of section 1023 of the Internal Revenue Code, most commentators concluded that corporate repur-chases generally provided more tax advantages than cross-purchase arrangements. See, e.g.,Kahn, supra note 146, at 11-43. The carryover basis rules set forth in section 1023 made that analy-sis more difficult and might have led to less use of buy-outs generally. See, e.g., Cavitch, Planningfor the Closely Held Corporation Under the Tax Reform Act, in 12 lNs-rrurE ON EsrATE PLANNING5-1, 5-2, 5-12 (P. Heckerling ed. 1978). It now appears, however, that section 1023 will be retroac-tively repealed (a conference committee of the House of Representatives and the Senate have soagreed; see [1980] FED. EST. & GuFr TAX REP. (CCH) 11,850 & Rep. Letter No. 145) and thus thatthe former analysis will continue to be applicable.

149. The 1977 Supplement to the Model Business Corporation Act Annotated, Second Edition.indicates that all states except Alabama impose statutory liability on directors for illegal distributions.See 1 MODEL Bus. CORP. Acr ANN., § 48 3.01-3.04 (2d ed. 1971, Supp. 1973 & Supp. 1977).Alabama does, however, refer to the fiduciary obligations of directors (Alabama Bus. Corp. Act. §97, ALA. CODE. § 10-2-5 (Michie 1975)), and that reference might be interpreted to mean that direc-tors may be liable for an illegal distribution if they do not use due care. Compare the discussion ofdirectors' common law liability for excessive distributions in Comment, The Statutory ResponsibilityofDirectors for Payment of Dividends Out of Capital. 35 YALE L.J. 870 (1926).

Most of the states with director liability statutes provide some statutory mechanism by which direc-tors found liable under such statutes may have actions over against shareholder recipients who knewof the illegality of the distribution. See I MODEL Bus. CORP. Acr ANN., § 48, 3.02 (2d ed. 1971,

Supp. 1973 & Supp. 1977).150. See the issues presented under the Model Business Corporation Act discussed in Kummert,

The Financial Provisions of the New Washington Business Corporation Act (pt. 2), 42 WASH. L.REV. 119 (1966); (pt. 3), 43 WASH. L. REV. 337 (1967).

392


edged.151 It would seem reasonable to assume from these circumstancesthat directors generally would desire a clear exception from liabilitywhere, in making a challenged distribution, they have relied in good faithupon information and opinions provided by lawyers, accountants, ap-praisers and other experts. 152 It also seems reasonable to assume that di-rectors would further prefer that any distribution not exculpated by suchexception be judged under the general standard of due care required ofdirectors. 153 Until recently, 154 however, many states have imposed abso-

151. Kehl has stated:In modem enterprise, the fund available as an accounting matter is determined entirely by thecorporation's accountants and lawyers. The director, unless he is himself an accountant or law-yer, is left to rely upon their determination as to whether the corporation has funds legallyavailable; his independent determination is actually made only on the business question whetherthe corporation should make a distribution from the fund he has been told is legally available.

D. KEHL, Com'oRA DIVIDEDs 244-45 (1941) (footnote omitted).152. It can be argued that in addition to their interest in administration of the legal limitations,

these experts also have at least an indirect interest in the law regulating the amount a corporation maydistribute to shareholders. Such an interest could be said to arise from the possibility that an expertmight be liable for negligent advice about the legality of a distribution and the expert's consequentdesire to have a regulatory scheme that reduced the frequency of such occurrences. While some ex-perts have been pursued for malpractice under some of the older statutory systems, see, e.g., Fisk v.Newsum, 9 Wn. App. 650, 513 P.2d 1035 (1973), the effect of a provision like the one described intext is to eliminate such actions by directors in any case where the director uses due care in the selec-tion of an expert and then relies in good faith on the information or opinion provided by the expert.But see New Haven Trust Co. v. Doherty, 75 Conn. 555, 54 A. 209 (1903) (directors liable fornegligence, despite reliance on counsel's opinion, on the ground that directors are not entitled to relyon legal advice contrary to the plain language of a statute). There remains the possibility that a thirdparty thought to be protected by the statutory scheme (e.g., a creditor of the corporation) could suethe expert for rendering negligent advice that caused harm to the creditor. Such an action would haveto overcome the heavily endorsed reasons for limiting such liability which the New York court of-fered in Ultramares Corp. v. Touche, Niven & Co., 255 N.Y. 170, 174 N.E. 441 (1931). It appears,however, that at least a limited number of cases have taken that precise step. See, e.g., Lucas v.Hamm, 56 Cal. 2d 583, 364 P.2d 685, 15 Cal. Rptr. 821 (1961); Hill v. Willmott, 561 S.W.2d 331(Ky. App. 1978) (dictum). See also Comment, Attorney Malpractice in California: The Liability of ALawyer Who Drafts An Imprecise Contract or Will, 24 U.C.L.A. REv. 422, 436-38 (1976).

It can also be argued that accountants have a further indirect interest in the law regulating theamount a corporation may distribute to shareholders. That interest might be based on the effect thatstatutory systems have upon accounting for the shareholders' equity in a corporation. Financial state-ments traditionally have separated shareholders' equity into components similar to the categories ofstated capital, capital surplus, and earned surplus used by the definition provisions (section 2) of theModel Business Corporation Act. See B. MEaczma, STocr, oLDEs' EQurry 87 (Accounting ResearchStudy No. 15, 1973). Melcher seems to say that if no legal significance were attached to these catego-ries, shareholders' equity would be subdivided into only two segments-shareholders' contributionsand retained earnings. She notes, however, that others argue that in such circumstances shareholders'equity should be shown as a single amount. Id. at 113. If that view were the accepted consequence,accountants presumably would prefer the simplicity of a statutory system that did not suggest catego-ries.

153. See discussion in Kummert, (pt. 2), supra note 150, at 414-16.154. In 1974, the Committee on Corporate Laws of the Section of Corporations, Banking and

Business Law of the American Bar Association approved revisions in the Model BusinessCorporation Act which appear to have the consequences described in text preceding note 153 supra.

Washington Law Review Vol. 55:359. 1980

lute liability on directors for illegal distributions, subject only to fairlynarrowly drawn exceptions.1 55 One might surmise from thesecircumstances that directors have been held liable for illegal distributionswith some frequency. But if that frequency can reasonably be estimatedfrom the number of appellate cases so holding, imposition of liability ondirectors for illegal distributions has been a rare event since World War11.156 Indeed, it appears that the number of cases since 1946 in which acourt was required to interpret a state's corporate financial provisions inorder to adjudicate the controversy before it is, in view of the number ofdistributions during the period, relatively small. 157

The small volume of litigation about corporate financial provisionsduring this period appears to be the product of a number of factors. The

See Report of Committee on Corporate Laws: Changes in the Model Business Corporation Act, 30Bus. LAW. 501 (1975). The 1977 Supplement to the Model Business Corporation Act Annotated (2ded.) indicates that, as of the date of the supplement, a substantial number of states adhered to theformer Model Act provisions (which imposed absolute liability for illegal distributions with adefense of good faith reliance on certain financial statements). See I MODEL Bus. CORP. Act ANN. §

48, 3.02 (2d ed. 1971, Supp. 1973 & Supp. 1977). For criticism of this relatively limited defense,

see Gibson, Surplus, So What? The ModelAct Modernized, 17 Bus. LAW. 476,489-90 (1962).155. See, e.g., Southern Cal. Home Builders v. Young, 45 Cal. App. 679, 188 P. 586 (1920).

The Young court affirmed the trial court's exclusion of evidence that directors had relied in good faithon financial statements prepared by employees, an appraisal of the corporation's assets, and an attor-ney's opinion that the dividend was proper. The court held that good faith was not a defense to astatute making it a crime to pay dividends out of stated capital.

156. A reasonably thorough search produced only 10 cases since 1945 in which liability had beenimposed on directors for illegal distributions. There were also nine cases holding shareholders liablefor illegal distributions. In addition, there were II more cases in which an apparently valid claim hadbeen asserted against directors for illegal distributions but in which, because of either the stage of theproceedings or lack of a proper party, a final judgment against the directors had not been entered. Thecase citations appear in the Appendix infra.

157. A reasonably thorough search produced 96 cases during the period in which a court wasrequired to interpret a state's corporate financial provisions in order to adjudicate the controversybefore it. Cases in which there is dicta regarding such provisions (i.e., statements not required to

decide an issue before the court) were excluded from this count. The list of cases included is en-larged by a sizeable number of cases in which the court's holding on an issue involving a state'sfinancial provisions was a preliminary premise in finding liability on issues unrelated to corporate law(e.g., tax cases are included in which the taxpayer's liability depended on the validity of a corporatetransaction, which in turn depended on the interpretation of the financial provisions).

The vast majority of these cases, 62 of them, concerned state provisions regulating repurchases ofshares, with 52 of these cases involving questions related to contracts to repurchase where paymentwas deferred. The remaining 10 cases involved a variety of other issues related to the validity of sharerepurchases.

The next most significant group of cases, numbering 25, involved interpretation of statutory lan-guage as to amounts that could legally be distributed by the corporation. There were four additionalcases in which the court determined that a claim asserted against shareholders for an illegaldistribution could not be sustained. There were three cases in which the court determined that a claimasserted against directors for an illegal distribution could not be sustained. Finally, there were twodecisions in which injunctions were granted against proposed distributions.

The case citations appear in the Appendix infra.


period was one in which the nation's economy remained relatively de-pression-free. Moreover, directors and their advisors had been alerted byrenowned pre-war cases158 to the threat of significant liability and proba-bly became more circumspect in making decisions about distributions. Itis also possible that statutory changes adopted in the 1950's and early1960's sufficiently clarified the circumstances giving rise to liability 59

that defendants either settled the controversies before trial or concededafter the trial court found certain basic issues against them. Finally, anumber of factors related to the interests of groups involved in the admin-istration of the legal limitations also appear to have operated to reducesignificantly the volume of litigation concerning such limitations.

The most important of these factors is the extensive use by large orlong-term creditors of contract provisions that supersede the statutoryprovisions with far more rigorous restrictions on financial distributions bythe corporate debtor. 160 Corporations bound by such covenants are notlikely candidates for litigation involving the statutory provisions sincedistributions made in compliance with the covenants will almost invari-ably satisfy the statutory limitations. 161 Moreover, the consequences ofviolating such covenants are generally so severe1 62 that few boards of di-rectors will intentionally take such action.

The extensive use of protective covenants by large or long-term credi-tors implies another reason why relatively few recent cases have involvedstate distribution limitations. Counsel for such creditors insists onstringent covenants because they have concluded that the protection af-forded to a creditor by a typical state statutory system is at best inadequateand at worst nonexistent. Most state systems permit, subject to the equita-

158. See, e.g., Randall v. Bailey, 288 N.Y. 280,43 N.E.2d43 (1942).A possible indirect measure of this awareness can be found in the relative significance of the mate-

rial dealing with distributions in casebooks used by law students during at least the early part of thisperiod. For example, one casebook, E. DODD & R. BAKER, CASES AND MATERIAIS ON CORPORATIONS

(1951), devoted 362 pages of a total of 1378 pages to the subject.159. See Adkins & Janis, Some Observations on Liabilities of Corporate Directors, 20 Bus.

LAW. 817, 829 (1965). The authors also suggest that improved accounting techniques have contribu-ted to the infrequency of such cases.

160. As to the frequency with which such covenants appear, see note 63 supra.161. Since most of the covenants limit dividends to the corporation's net income after a stated

date, it is mathematically possible that a corporation desiring to pay a dividend could satisfy the co-venant and still have problems with a dividend statute using earned surplus as the measure of divi-dends. Most of the corporations in the survey discussed in note 63 supra, however, had substantialamounts of surplus, which suggests that loans were not made (at least absent additional covenants)unless the corporation could easily pass the state dividend restriction.

162. A distribution made in breach of a dividend restriction covenant typically constitutes anevent of default under the loan indenture, the primary consequence of which is that the principal maybe immediately due and owing. See AMERIcAN BAR FOUNDATION, COMMENTARIES ON INDENTURES 204-20(1971). Such acceleration will cause immediate equitable insolvency.


ble insolvency limitation, distribution of assets equal to the corporation'ssurplus. 16 3 But many established corporations have large enough surplusbalances that the surplus restriction is not even considered in determiningthe amount of a distribution. 164 Further, even in cases where the surpluslimitation appears to restrict a corporation's ability to make a distribution,surplus may be created by a change in accounting principles, 165 by therecognition of unrealized appreciation in the value of the corporation'sassets, 166 or by a reduction of stated capital. 167 Thus the distributions ofmany of the corporations not subject to covenants are limited only by therather broad confines of the equitable insolvency test.

The extensive use of protective covenants has further implications con-ceming the probable parties to a distribution controversy and theirrepresentatives. If substantially all the corporations with either a large ora long-term creditor can be eliminated from the universe of potential cor-porate parties to such litigation, it seems probable that most of the re-maining corporations will be small and will have only trade credit out-standing. 168 Two further related inferences may be drawn from the size of

163. See 1 MODEL Bus. CORP. AcT ANN. § 45(a) 3.01-3.03 (2d ed. 1971, 1973 Supp. & 1977Supp.).

164. See W. CARY, supra note 91, at 1484-85.165. For example, assume that the corporation has an inventory of goods held for sale in the

ordinary course of business that has been priced for purposes of accounting statments using Last-In-First-Out (LIFO) pricing assumptions. If the layers of inventory giving rise to the inventory'scarrying value are relatively old, and current replacement prices have followed the general inflation-ary trend, the carrying value of the inventory under First-In-First-Out (FIFO) assumptions will besignificantly higher than the accounting statements report. If the corporation's accountant will ap-prove the change in accounting principles, the effect of a change in accounting principle from LIFO

to FIFO pricing would be to increase surplus of prior periods by roughly the increase in the value ofthe inventory to the beginning of the current year, less the taxes associated with that change. SeeAMERICAN INST. OF CERTIFIED PUBLIC AccouNTANTs, AccoUNTNG PRINCIPLES BOARD OPINION 20 (1971).

A major problem with this suggestion is that the corporation must also shift from LIFO to FIFO for

tax purposes. See I.R.C. § 472(c). If such a change is approved by the Commissioner, current andfuture taxes will be higher.

166. For a discussion of recognition of unrealized appreciation under the Model Business Corpo-ration Act, see Kummert, The Financial Provisions of the New Washington Business CorporationAct (pt. 2), 42 WASH. L. REv. 119, 148-53 (1966). Cf. Clark, The Duties of the Corporate Debtorto Its Creditors, 90 HARv. L. REv. 505, 557 (1977) (refers to the porosity of the corporation lawprotections for creditors).

167. For an analysis of the procedure involved under the Model Business Corporation Act,which involves, at most, shareholder action, see Kummert, The Financial Provisions of the New

Washington Business Corporation Act (pt. 3), 43 WASH. L. Rav. 337,356-68 (1967).168. Many small corporations will not be in the class of potential litigants. When such corpora-

tions desire to pass funds on to shareholders, tax considerations are likely to cause the vast majorityof such distributions to be made by means of salary payments rather than by means of dividends orrepurchases of shares. The principal tax consideration is that a corporation can deduct reasonablesalary payments in determining its taxable income but cannot deduct payments for either dividends orshare repurchases.

It is also clear from the predominance of installment repurchase transactions in the number of cases


the corporation and the type of creditor typically involved in suchlitigation: the amount in controversy is likely to be small; and counsel onboth sides of the litigation are likely not to be specialists in corporate mat-ters. There is ample evidence that many general practitioners have con-siderable difficulty grappling with the complexities of a typical state divi-dend regulation system. 169 Such difficulty will result in less litigationinvolving such provisions whenever counsel is not aware that potentialstatutory violations exist in the facts being studied, does not pursue anissue presenting a concept that is hard to articulate, or does not try anissue because of inability to gauge a judge's reaction to it. This last factor

since 1946 (see note 157 supra, and cases cited in Appendix infra) that a significant number of smallcorporations enter into installment repurchase contracts. It seems unlikely, however, that the numberof such transactions approaches the number of occasions in which a small corporation uses salarypayments as a means of distributing funds to its shareholders, in part because the tax rules in effectpreclude pro rata redemptions of shares.

It is possible that salary payments may in the event of financial difficulty be challenged by credi-tors as disguised dividends. Cf. Treas. Reg. § 1.162-7(b)(1) (1958) (presenting the argument theInternal Revenue Service typically makes in analogous tax cases). It appears, however, that a state'sfraudulent conveyance statute may provide an easier, more direct line of attack for this purpose than astate's dividend statutes. Under the Uniform Fraudulent Conveyances Act (UFCA), a creditor's rem-edy is to avoid fraudulent transfers and thus to pursue the shareholder recipients. UFCA section 5declares fraudulent any gratuitous or unfair transfer by a debtor in business if, after the transfer, theproperty remaining in the debtor's hands is an unreasonably small capital. UNIFOri FRAUDULENT

CoNvEYANcEs Act § 5. This test may afford creditors more protection than the state dividend restric-tions. See Clark, supra note 166, at 555. In addition, in such cases it may be more profitable topursue the recipient shareholders rather than the directors. See B. MANNING, A CONCISE TExrMOOK ON

LEGAL CAPrrAL 88 (1977).169. Empirical evidence on this subject is admittedly indirect in the sense that it must be based

on court statements that obviously are in error. My hypothesis is, however, that judges would notmake such errors if counsel had presented clear arguments on the issues raised.

As an example of such confusion, consider the following statements:As to the redemption scheme, it is true that RCW 23A.08.030 prohibits a corporation from

purchasing its own stock except out of unreserved and unrestricted capital surplus. Jackson v.Colagrossi, 50 Wn. 2d 572, 313 P.2d 697 (1957). However, the statute does not prevent anagreement for the future purchase of stock out of earned surplus; it only prohibits the actualpurchase if, at the time the purchase is made, there is insufficient unreserved and unrestrictedcapital surplus to do so. Burk v. Cooperative Fin. Corp., 62 Wn. 2d 740, 384 P.2d 618 (1963).

Fisk v. Newsum, 9 Wn. App. 650, 653, 513 P.2d 1035, 1038 (1973). RCW 23A.08.030 providesthat a corporation can repurchase its shares only to the extent of unreserved and unrestricted earnedsurplus. Capital surplus can be used as a measuring factor for such transactions only if the articles ofincorporation so provide or if the holders of a majority of all shares in the corporation approve. Jack-son v. Colagrossi and Burk v. Cooperative Finance Corp. both involved the validity of repurchasesunder an earlier and differently stated statute. The court's statement that the validity of installmentpayments under the surplus measurement test will be determined as each payment is made ignores thedifference in language in RCW 23A.08.030 related to the surplus test ("purchase of [the corpora-tion's] own shares.., shall be made only to the extent of... earned surplus") and the clause relatedto the insolvency test ("No purchase of or payment for its own shares shall be made at a time whenthe corporation is insolvent .... ). WASH. RV. CoDE § 23A.08.030 (1979) (emphasis added). Theitalicized language in the insolvency clause has led most commentators to believe the court'sconstruction of the surplus test is incorrect. See D. HEiwrrz, BustNErss P.ANNrNo 438 (1966).

397


may be accentuated by a reluctance on the part of judges to engage issuesthey feel are inordinately complex. 170

A final factor in the lack of litigation may be counsel's feeling that theebb and flow of social values has shifted against such litigation. Casesholding directors liable for breach of the duty of care have always beenrenowned because of their infrequency. 171 Cases protecting creditors'rights are to be sure still numerous, but generally it seems that courts areless sympathetic to the creditor's plight than they were, say, forty yearsago.172 In particular, courts appear less willing to protect a party extend-ing credit to a corporation when that party has not bothered to take well-advertised steps to protect himself or herself. 173

Whatever the reasons for the lack of litigation involving corporate fi-nancial provisions, critics argue that this lack indicates that state regula-tion of financial distributions by corporations no longer has socialutility. 174 A complete analysis of that argument requires a determinationwhether any regulatory response, including nonregulation, promotessome or all of the policy objectives previously surveyed and whetherthese benefits exceed the costs that will be incurred under any systemchosen. That analysis is the subject of the second part of this article.

170. See B. MANNING, A CONCISE TEXTBOOK ON LEGAL CAPITAL (1977). As Manning states:After embarking bravely upon the adventure of regulating shareholder distributions in the in-

terest of creditors, both court and legislature recoiled from actively carrying through with thatenterprise as they came to realize, more or less consciously, the enormity and complexity of lawbuilding that would be necessary to make the system really work.

Id. at 62.171. See, e.g., Bishop, Sitting Ducks and Decoy Ducks: New Trends in the Indemnification of

Corporate Directors and Officers, 77 YALE L.J. 1078, 1095 (1968): "The hard fact is that cases inwhich directors of business corporations are held liable, at the suit of stockholders, for mere negli-gence are few and far between." That conclusion is confirmed by Cary & Harris, Standards of Con-duct Under Common Law, Present Day Statutes and the Model Act, 27 Bus. LAW. 61, 62-64 (Feb.1972). Some might argue that Francis v. United Jersey Bank, 162 N.J. Super. 355, 392 A.2d 1233(1978), signals a different attitude with its stem pronouncements concerning an inattentive director.But that case appears to rest finally on giving preference to innocent creditors rather than to the heirsof the inattentive director who had looted the corporation.

Conard points to three factors contributing to the general lack of actions involving directornegligence: the lack of indicators that directorial error caused the loss, corporate (director) disinclina-tion to sue directors, and the expense of investigation, preparation, and suit. Conard, A BehavioralAnalysis of Directors' Liability for Negligence, 1972 DUKE L.J. 895, 905-07. The first and thirdundoubtedly contribute to the lack of actions on director liability.

172. See, e.g., Coogan, Article 9-An Agenda for the Next Decade, 87 YALE L.J. 1012, 1025(1978).

173. See, e.g., Hamilton, The Corporate Entity, 49 T x. L. REv. 979, 986-87 (1971).174. See, e.g., B. MANNING, supra note 170, at 90, 108.

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APPENDIXA. Cases in which liability was imposed on directors for illegal distribu-

tions:

Huron Milling Co. v. Hedges, 257 F.2d 258 (2d Cir. 1958)In re Gribbin Supply Co., 371 F. Supp. 664 (N.D. Tex. 1974)Cunningham v. Jaffe, 251 F. Supp. 143 (D.S.C. 1966)King v. Coosa Valley Mineral Prods. Co., 283 Ala. 205, 215 So. 2d 275

(1968)Hoover v. Galbraith, 7 Cal. 3d 519, 498 P.2d 981, 102 Cal. Rptr. 733

(1972)Sears v. Weissman, 6 Ill. App. 3d 827, 286 N.E.2d 777 (1972)Burke v. Marlboro Awning Co., 330 Mass. 294, 113 N.E.2d 222 (1953)Moseley v. Briggs Realty Co., 320 Mass. 278, 69 N.E.2d 7 (1946)Berks Broadcasting Co. v. Craumer, 356 Pa. 620, 52 A.2d 571 (1947)Baker v. Mutual Loan & Inv. Co., 213 S.C. 558, 50 S.E.2d 692 (1948) -

B. Cases in which liability was imposed on shareholders for illegal dis-tributions:

In re Kettle Fried Chicken of America, Inc., 513 F.2d 807 (6th Cir. 1975)Steph v. Branch, 255 F. Supp. 526 (E.D. Okla. 1966), affd, 389 F.2d 233

(10th Cir. 1968)United States v. Seyler, 142 F. Supp. 408 (W.D. Pa. 1956)Gray v. Sutherland, 124 Cal. App. 2d 280,268 P.2d 754 (1954)Reilly v. Segert, 31 Ill. 2d 297, 201 N.E.2d 444 (1964)Pastemack v. Louisana & Arizona Lands, Inc., 254 So. 2d 142 (La. App.

1971)Kleinberg v. Schwartz, 87 N.J. Super. 216, 208 A.2d 803 (Super. Ct. App.

Div. 1965)King Mach. Co. v. Caporaso, 2 N.J. Super. 230, 63 A.2d 270 (Super. Ct.

Ch. Div. 1949)Jackson v. Colagrossi, 50 Wn. 2d 572, 313 P.2d 697 (1957)See also Guaranteed Reserve Life Ins. Co. v. Holzwarth, 148 Colo. 366,

366 P.2d 377 (1961), in which the corporation's president was held liablefor an illegal dividend under a state statute.

C. Cases in which a valid claim was asserted against directors but inwhich afinal judgment against them was not entered:

Loftus v. Mason, 240 F.2d 428 (4th Cir. 1957)Aiken v. Peabody, 168 F.2d 615 (7th Cir. 1947)Fitzgerald v. Marshall, 161 F. Supp. 470 (D. Colo. 1958)

399


UMF Systems, Inc. v. Eltra Corp., 17 Cal. 3d 753, 553 P.2d 225, 132 Cal.Rptr. 129 (1976)

England v. Christensen, 243 Cal. App. 2d 413, 52 Cal. Rptr. 402 (1966)Rosebud Corp. v. Boggio, - Colo. App. -, 561 P.2d 367 (1977)Precision Extrusions, Inc. v. Stewart, 36 I1l. App. 2d 30, 183 N.E.2d 547

(1962)Des Moines Bank & Trust Co. v. George M. Bechtel & Co., 243 Iowa

1007, 51 N.W.2d 174 (1952)David McDonough, Inc. v. Berger, 22 Misc. 2d 646, 192 N.Y.S.2d 702

(Sup. Ct. 1959)Waters v. Spalt, 22 Misc. 2d 937, 80 N.Y.S.2d 681 (Sup. Ct. 1948)Robertson's, Inc. v. Renden, 189 N.W.2d 639 (N.D. 1971)

D. Cases involving contracts to repurchase where payment was de-ferred:

In re Flying Mailmen Service, Inc., 539 F.2d 866 (2d Cir. 1976)In re National Tile & Terrazzo Co., 537 F.2d 329 (9th Cir. 1976)Palmer Millinery Co. v. Spar, 487 F.2d 503 (2d Cir. 1973)Witter v. Triumph Smokes, Inc., 464 F.2d 1078 (5th Cir. 1972)McConnell v. Estate of Butler, 402 F.2d 362 (9th Cir. 1968)In re Trimble Co., 339 F.2d 838 (3d Cir. 1964)Mountain State Steel Foundries, Inc. v. Commissioner, 284 F.2d 737 (4th

Cir. 1960)In re Kranz Candy Co., 214 F.2d 588 (7th Cir. 1954)Jarroll Coal Co. v. Lewis, 210 F.2d 578 (4th Cir. 1954)In re Peoples Loan & Inv. Co., 316 F. Supp. 13 (W.D. Ark. 1970)In re Belmetals Mfg. Co., 299 F. Supp. 1290 (N.D. Cal. 1969), affd per

curiam sub nom. Eranosian v. England, 437 F.2d 1355 (9th Cir. 1971)Baxter v. Lancer Indus. Inc., 213 F. Supp. 92 (E.D.N.Y.), appeal dis-

missed, 324 F.2d 286 (2d Cir. 1963)In re Dawson Bros. Constr. Co., 218 F. Supp. 411 (N.D.N.Y. 1963)Georesearch, Inc. v. Morriss, 193 F. Supp. 163 (W.D. La. 1961), affdper

curiam, 298 F.2d 442 (5th Cir. 1962)In re Mathews Constr. Co., 120 F. Supp. 818 (S.D. Cal. 1954)In re Semolina.Macroni Co., 109 F. Supp. 453 (D.R.I. 1952)In re Bell Tone Records, Inc., 86 F. Supp. 806 (D.N.J. 1949)Cutter Labs, Inc. v. Twining, 221 Cal. App. 2d 302, 34 Cal. Rptr. 317

(1963)Mindenberg v. Carmel Film Prods., Inc., 132 Cal. App. 2d 598, 282 P.2d

1024 (1955)Schreiber v. San Joaquin Exploration Co., 125 Cal. App. 2d 171, 270 P.2d

19 (1954)Flynn v. California Casket Co., 105 Cal. App. 2d 196, 233 P.2d 131 (1951)Goodman v. Global Indus., 80 Cal. App. 2d 583, 182 P.2d 300 (1947)

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Garrity v. Radel, 151 Conn. 349, 197 A.2d 775 (1964)Naples Awning & Glass, Inc. v. Cirou, 358 So. 2d 211 (Fla. App. 1978)La Voy Supply Co. v. Young, 84 Idaho 120, 369 P.2d 45 (1962)American Heritage Inv. Corp. v. Illinois Nat'l Bank, 63 Ill. App. 3d 762,

386 N.E.2d 905 (1979)Cate v. Pagel-Clikeman Co., 87 111. App. 2d 65, 230 N.E.2d 387 (1967)Collins v. Universal Parts Co., 260 So. 2d 702 (La. App. 1972)Kraft v. Rochambeau Holding Co., 210 Md. 325, 123 A.2d 287 (1956)Anderson v. K.G. Moore, Inc., 78 Mass. App. Ct. 548, 376 N.E.2d 1238,

cert. denied, 439 U.S. 927 (1978)Van Kampen v. Detroit Bank & Trust Co., 40 Mich. App. 589, 199

N.W.2d 470 (1972)Tracy v. Perkins-Tracy Printing Co., 278 Minn. 159, 153 N.W.2d 241

(1967)Hawkins v. The Mall, Inc., 444 S.W.2d 369 (Mo. 1969)Burg v. Bonne Terre Foundry Co., 354 S.W.2d 303 (Mo. App. 1962)American Hosp. & Life Ins. Co. v. Kunkel, 71 N.M. 164, 376 P.2d 956

(1962)In re Farah's Estate, 13 N.Y.2d 909, 193 N.E.2d 641, 243 N.Y.S.2d 858

(1963)Bulger v. Colonial House of Flushing, Inc., 281 App. Div. 847, 119

N.Y.S.2d 233 (1953)Nakano v. Nakano McGlone Nightingale Advertising, Inc., 84 Misc. 2d

905, 377 N.Y.S.2d 996 (Sup. Ct. 1975)In re Klaum's Will, 58 Misc. 2d 262, 294 N.Y.S.2d 877 (Sup. Ct. 1968)Murphy v. George Murphy, Inc., 7 Misc. 2d 647, 166 N.Y.S.2d 290 (Sup.

Ct. 1957)Christie v. Fifth Madison Corp., 123 N.Y.S.2d 795 (Sup. Ct. 1953)Bolmer Bros., Inc. v. Bolmer Constr. Co., 114 N.Y.S.2d 530 (Sup. Ct.

1952)Browder v. Mutual Tool & Die, Inc., 54 Ohio Op. 2d 241, 263 N.E. 2d 785

(1970)Goldberg v. Peltier, 75 R.I. 314, 66 A.2d 107 (1949)Williams v. Nevelow, 513 S.W.2d 535 (Tex. 1974)Hall v. Weller, Hall & Jeffery, Inc., 497 S.W.2d 374 (Tex. Civ. App.

1973)Triumph Smokes, Inc. v. Sarlo, 482 S.W.2d 696 (Tex. Civ. App. 1972)Rainford v. Rytting, 22 Utah 2d 252,451 P.2d 769 (1969)Owyhee, Inc. v. Robbins Marco Polo, 17 Utah 2d 181, 407 P.2d 565

(1965)Burk v. Cooperative Finance Corp., 62 Wn. 2d 740, 384 P.2d 618 (1963)Fisk v. Newsum, 9 Wn. App. 650, 513 P.2d 1035 (1973)Bishop v. Prosser-Grandview Broadcasters, Inc. 3 Wn. App. 43, 472 P.2d

560(1970)


E. Cases involving other issues concerning the validity of share repur-chases:

Brockington v. Scott, 381 F.2d 792 (4th Cir. 1967) (shareholder's option totender stock to corporation invalidated by corporation's insolvency)

Tiedje v. Aluminum Taper Milling Co., 46 Cal. 2d 450, 296 P.2d 554(1956) (former shareholder's right to void illegal repurchase)

Sanchez v. Centro Mexicano of Sacramento, I Cal. App. 3d 756, 81 Cal.Rptr. 875 (1969) (conditions of the right of first refusal inapplicablewhere corporation had insufficient surplus to consummate purchase)

Goldman v. Coppola, 149 Conn. 317, 179 A.2d 817 (1962) (effect of fail-ure to file certificate of repurchase)

In re Estate of Brown, 130 111. App. 2d 514, 264 N.E.2d 287 (1970) (optionempowering corporation or its designee to purchase shares not invali-dated by corporation's lack of surplus)

Moro v. Soldo, 143 N.Y.S.2d 863 (Sup. Ct. 1955) (effect of combinedsale-repurchase of shares)

Cooper v. Brook, 197 Misc. 575, 95 N.Y.S.2d 23 (City Ct. N.Y. 1950)(necessary allegations for suit in contract to repurchase)

Lowry v. Sunday Creek Coal Co., 2 Ohio App. 2d 260, 207 N.E.2d 678(1964) (interpreting exception for repurchases from employee plans)

Conine v. Liekam, 570 P.2d 1156 (Okla. 1977) (interpreting scope of set-tlement of debt exception)

Kirkpatrick v. Jacobson's Lifetime Bldgs., Inc., 467 P.2d 489 (Okla. 1970)(interpreting scope of settlement of debt exception)

F. Cases interpreting statutory language to determine amounts legallydistributable:

United States v. Ogilvie Hardware Co., 330 U.S. 709 (1947)Hamilton Mfg. Co. v. United States, 214 F.2d 644 (7th Cir. 1954)United States v. Seiberling Rubber Co., 207 F.2d 585 (6th Cir. 1953)United States v. Riely, 169 F.2d 542 (4th Cir. 1948)International Ticket Scale Corp. v. United States, 165 F.2d 358 (2d Cir.

1948)Jones v. First Nat'l Bldg. Corp., 155 F.2d 815 (10th Cir. 1946)Maffia v. America Woolen Co., 125 F. Supp. 465 (S.D.N.Y. 1954)Beneficial Corp. v. Reading & Sw. St. Ry., 91 F. Supp. 803 (E.D. Pa.),

affd per curiam, 185 F.2d 238 (3d Cir. 1950)William H. Haskell Mfg. Co. v. United States, 91 F. Supp. 26 (D.R.I.

1950)Nemours Corp. v. United States, 91 F. Supp. 859 (D. Del. 1950)Armour & Co. v. Harrison, 87 F. Supp. 635 (N.D. Ill. 1949)Grand Traverse Hotel Co. v. United States, 79 F. Supp. 860 (W.D. Mich.

1948)

Vol. 55:359, 1980


Beal v. United States, 73 F. Supp. 518 (N.D. Okla. 1947)George E. Warren Co. v. United States, 76 F. Supp. 587 (D. Mass. 1948)Philadelphia Carpet Co. v. United States, 68 F. Supp. 712 (E.D. Pa. 1946)Scripto'Mfg. Co. v. Allen, 64 F. Supp. 804 (M.D. Ga. 1946)Brooks Equip. & Mfg. Co. v. United States, 95 F. Supp. 247 (Ct. Cl. 1951)International Paper Co. v. United States, 88 F. Supp. 891 (Ct. Cl. 1950)National Sanitary Co. v. Commissioner, 6 T.C. 166 (1946)Weinberg v. Baltimore Brick Co., 35 Del. Ch. 225, 114 A.2d 812 (1955)Morris v. Standard Gas & Elec. Co., 31 Del. Ch. 20, 63 A.2d 577 (1949)Coast Cities Coaches, Inc. v. Whyte, 102 So. 2d 848 (Fla. App. 1958)Graham v. Louisville Transit Co., 243 S.W.2d 1019 (Ky. 1951)Dohme v. Pacific Coast Co., 5 N.J. Super. 477, 68 A.2d 490 (Super. Ct.

Ch. Div. 1949)Woodson v. Lee, 73 N.M. 425, 389 P.2d 196 (1963)

G. Cases in which a claim was asserted against shareholders that couldnot be sustained:

Palmer v. Justice, 322 F. Supp. 892 (N.D. Tex.), affd, 451 F.2d 371 (5thCir. 1971)

Fried v. Cano, 167 F. Supp. 625 (S.D.N.Y. 1958)Hannigan v. Italo Petroleum Corp. of America, 45 Del. 593, 77 A.2d 209

(1950)Quillian Int'l Truck & Tractor, Inc. v. Livesay, 184 So. 2d 668 (Fla. App.

1966)

H. Cases in which a claim was asserted against directors that could notbe sustained:

Providence State Bank v. Bohannon, 426 F. Supp. 886 (E.D. Mo. 1977),aff'd, 572 F.2d 617 (8th Cir. 1978).

TWM Homes, Inc. v. Atherwood Realty & Inv. Co., 214 Cal. App. 2d826, 29 Cal. Rptr. 887 (1963)

Webb City Undertaking Co. v. Sinclair, 240 Mo. App. 958, 225 S.W.2d138 (1949)

I. Cases granting injunctions against proposed distributions:

Firebaugh .v. Scoville, Inc., 334 111. App. 395, 79 N.E.2d 531 (1948)City of Philadelphia v. Philadelphia Transp. Co., 386 Pa. 231, 126 A.2d

132 (1956)

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Documents

State Statutory Restrictions on Financial Distributions by